It’s risky – but this pension trick can double tax-free cash
For many, the tax-free “lump sum” is the major selling point of a pension. In most cases, savers can withdraw 25pc of their pension without paying any tax. But you can obtain far larger sums – even as much as twice the original offer – depending on which type of pension you make the withdrawal from.
In “final salary” pensions the cash sum is calculated approximately as a quarter of 20 times the starting income. A pension that will pay £10,000 a year is valued at £200,000. That means you can withdraw £50,000 of cash tax-free.
But swapping a final salary pension for a “defined contribution” pension could boost that figure further. It’s all because of historically high “transfer values”, the amount a pension scheme will give you to exit the scheme. It is in the company’s interest to do this as the cost of funding “final salary” pensions has spiralled in recent years. This week Tesco announced its first dividend in three years, which was possible, in part, as its pension obligations fell.
Common transfer offers seen today are multiples of 30, 35 or even 40 times the starting income from a final salary scheme. The same £10,000 might be valued at £400,000, if transferred out, which would in turn produce £100,000 of tax-free cash. But remember, with a defined contribution pension you bear all the investment risk yourself.
Analysis by Tideway, a pension transfer advice firm, also highlights how those needing to take cash earlier lose out. Final salary schemes normally apply discounts for taking a pension before the “normal” retirement age. Tideway’s James Baxter explained how retiring just five years early, at 55 instead of 60, could knock off 20pc of the starting pension. This would lower the tax-free cash able to be withdrawn further.
Defined contribution pensions, on the other hand, are freely accessible from the age of 55 onwards.
Mr Baxter said: “Even if you don’t need the tax-free cash sum, it will usually make sense to invest it using Isas, or to take advantages of tax allowances.”
However, experts fear the City watchdog may be preparing to crack down on transfers. The Financial Conduct Authority reviewed 88 cases and found 53pc were ill-advised in recommending a transfer. Savers must take regulated financial advice if transferring a pension worth £30,000 or more. However, the right to transfer exists irrespective of the adviser recommending a transfer or not.
Tesco has managed to slash the accounting deficit in its pension fund