Can I Take A Tax-Free Lump Sum on Retirement?

Since with a defined benefit scheme (see Occupational defined benefit schemes) you do not build up a pension fund as such, you cannot simply take a tax-free lump sum out of your fund on retirement. Instead, you can choose to receive a tax-free lump sum by agreeing to reduce the amount of annual pension you will receive. You will generally be offered an exchange rate to determine how much money you will receive in exchange for each pound of pension you give up. For example, you may be offered twenty pounds for every one pound of annual pension you give up. This exchange rate is also known as a commutation factor, and exchanging a part of your annual income for a lump sum is known as a commutation.

If your annual pension would be, as above, £11,733, but you believed that £10,000 would be enough to cover your expenses, perhaps because you had other sources of savings, you may wish to reduce your annual pension to £10,000 and take the rest as a tax-free lump sum. Your pension scheme offers you £20 for each £1 of pension you give up. You give up £1,733 of annual pension and are entitled to a tax-free lump sum of £34,660. This may seem like a very generous offer, and it is worth taking the lump sum if you feel that you need the money to fulfil retirement plans like a round-the-world trip. It may not be a good idea to take the lump sum if you only want to invest it for extra annual pension. Remember you will not be guaranteed to make as much annually from your investment as you would have had by declining the lump sum and taking the extra pension from your scheme provider. You should also bear in mind that with pensioners living longer and longer you may need as much annual pension as possible. For more information on investments see Other Investment Opportunities.

Many pension schemes also offer a lump sum without a commutation. The tax rules, which may or may not be the same as your pension scheme rules, allow people a maximum lump sum equal to the lesser of:

• a quarter of the standard lifetime allowance, currently £1.6 million, making a maximum lump sum of £400,000
• a quarter of: the lump sum + (the annual pension x 20)
  

Thus, if you have an annual pension of £15,000 from your scheme you are entitled to a maximum lump sum of £100,000.

• £100,000 is one quarter of £100,000 + (£15,000 x 20) = £400,000

In practice many pension scheme providers will offer their members tax-free lump sums of a lower value than these maximum lump sums. Often the maximum tax-free lump sum you are entitled to will be set out in the rules of your pension scheme contract. The tax rules dictate however that any lump sum you choose to take must be taken within three months of your retirement and before you reach seventy-five years old.