Full Pension v Reduced Pension and Tax Free Cash
Published / Last Updated on 13/08/2020
Should I take all pension income or should I take reduced pension income and tax free cash lump sums?
To establish a net return that you would need to achieve on the tax free lump sum to match the pension income (if you had kept the full pension), divide the reduced income amount by the tax free lump sum and multiply by 100 to get gross % yield required.
E.g. Full Company Pension £20,000pa v £5,000pa Reduced Pension to £15,000pa and Tax Free Lump
If, you take the reduced pension and tax free lump sum of:
£15,000 pa pension + £45,000 lump sum = Reduced Pension £5,000 divided by £45,000 (lump sum) X 100 = 11% gross yield required to match pension income.
- After tax, for a basic rate tax payer = 11%pa less 20% basic rate tax = 8.88%pa net or as will have had paid it tax free. Could you achieve either a tax free or net tax return of 8.88%pa? We think not.
- After tax, for a higher rate tax payer = 11%pa less 40% higher rate tax = 6.60%pa net or as will have had paid it tax free. Could you achieve either a tax free or net tax return of 6.60%%pa? We think difficult.
- After tax, for an additional rate tax payer = 11%pa less 45% basic rate tax = 6.05%pa net or as will have had paid it tax free. Could you achieve either a tax free or net tax return of 8.88%pa? We think difficult.
£15,000 pa pension + £60,000 lump sum = Reduced Pension £5,000 divided by £60,000 (lump sum) X 100 = 8.33% gross yield required to match pension income.
- After tax, for a basic rate tax payer = 8.33%pa less 20% basic rate tax = 6.66%pa net or as will have had paid it tax free. Could you achieve either a tax free or net tax return of 6.66%pa? We think difficult.
- After tax, for a higher rate tax payer = 8.33%pa less 40% higher rate tax = 5%pa net or as will have had paid it tax free. Could you achieve either a tax free or net tax return of 5%pa? We think achievable.
- After tax, for an additional rate tax payer = 8.33%pa less 45% basic rate tax = 4.58%pa net or as will have had paid it tax free. Could you achieve either a tax free or net tax return of 4.58%pa? We think achievable.
For private pensions such as personal pensions, SIPPS, stakeholder pensions and defined contribution (investment linked) schemes it is simply a matter of comparing the open market annuity rate offered compared to the next growth yield required after taxes in much the same way as above.
E.g. Personal Pension Fund worth £100,000 secures an open market annuity income of £4,000pa. This means an annuity rate of 4%. By taking the 25% tax free lump of £25,000, you would then need to return on the £25,000 of 3.2%pa for a basic rate 20% tax payer, 2.4%pa for a higher rate 40% tax payer and 2.3%pa for an additional 45% tax payer to match watch you would have got in an annuity of 4%pa before tax.
