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Tax Free Cash - What is it ? How Does it Work ? |
| For some people, a cash lump sum could help them achieve a substantial change to their personal circumstances.
Many people are aware that they will receive a tax free lump sum when they take their pension. The lump sum is typically 25% of the whole fund value. For example, if their pension fund is worth £150,000, then they could receive a tax free lump sum of £37,500.
Many people however are loath to take this lump sum as they believe they will also have to start taking a monthly pension income. Some Pension contracts do insist that you have to take an income if you take your tax free cash, but there are other options open to you.
The good news is that changes to the pension rules in April 2006 make it far easier for people to take the lump sum from their pension now, while leaving the rest of the pension in place to take when a monthly income does become necessary.
If you are aged between 55 and 75, we can help you realise a lump sum from your existing pension fund. You can also decide whether to take no monthly income, an enhanced monthly income or somewhere in between.
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A WORD OF WARNING : Your pension is a very valuable asset aimed at providing you with an income when you are no longer working. Once a decision is made to take the benefit from your pension, it is irreversible. We would advise you only to take a lump sum from your pension if it can be used to make a permanent change to your financial circumstances. New cars and holidays may sound attractive, but we would ask you to consider the longer term impact to your lifestyle if you were to use the benefit for such a purchase.
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Tax Free Cash - How to do it |
| The most common means of taking a tax free lump sum from your pension fund (but no monthly income) is to use something called a Drawdown contract.
Unlike an annuity, you do not exchange your pension fund for cash and income. Instead you leave the fund invested and take the tax free cash directly from the fund. The rest of the fund remains invested in exactly the same way as your current pension fund.
This approach has a number of benefits and some risks, all of which we will explain in the “What you need to decide” section at the bottom of this page.
If this all becomes too confusing for you, call us on 0845 83 87 811 and one of our trained advisers will give you all the information you need in simple easy to understand language.
Many people get confused about Drawdown, so let us try to make it simple for you:
You may currently have a personal pension, which you may or may not contribute towards. That pension fund is invested in one or more funds of your choice. Hopefully with prudent fund selection over time your pension fund will grow.
A drawdown pension contract works in exactly the same way.
Things only change when you decide to take your lump sum and / or some income. This is known as “taking benefits” and therefore “putting the pension into Drawdown” or "Crystalising Benefits".
At this point you can no longer contribute to this pension contract. However you can contribute to any other pension fund that is not in Drawdown.
When you take the benefits from a Drawdown contract, the tax free cash will be taken directly from the fund. The contract also assumes that you want to take an income, but if you are only interested in your tax free lump sum, you can select to take zero (0%) income. This means that the remainder of your fund remains invested, and so has the potential to grow.
If you are interested in taking some income as well as your tax free cash, then please see the Slow Start Annuity page.
The concept of leaving your pension fund invested after taking tax free cash can be a potential benefit.
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| This chart demonstrates what would happen to a pension fund of £100,000 that was put into drawdown by a customer aged 55. It assumes the pension fund grows each year by 3%.
The chart below does not allow for any product costs or fund charges.
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| Pension fund before Drawdown |
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£100,000 |
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| Tax Free Cash (TFC) to customer |
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£25,000 |
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| Pension Fund after Tax Free Cash |
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£75,000 |
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| Pension Fund after 1 year (Aged 56) |
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£77,250 |
| Pension Fund after 2 years (Aged 57) |
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£79,567 |
| Pension Fund after 3 years (Aged 58) |
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£81,954 |
| Pension Fund after 4 years (Aged 59) |
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£84,413 |
| Pension Fund after 5 years (Aged 60) |
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£86,945 |
| Pension Fund after 6 years (Aged 61) |
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£89,554 |
| Pension Fund after 7 years (Aged 62) |
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£92,240 |
| Pension Fund after 8 years (Aged 63) |
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£95,007 |
| Pension Fund after 9 years (Aged 64) |
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£97,858 |
| Pension Fund after 10 years (Aged 65) |
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£100,793 |
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As stated above, cost and charges would reduce the figures above.
We have assumed 3%, even though the FSA recommended minimum growth rate is 5%.
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| What this demonstrates is that, with a moderate investment performance, the amount taken from the fund over a 10 year period has been replaced.
You can’t however use the growth to take a further lump sum.
If this scenario appeals to you, then consider making use of the cash or deposit pension funds which are made available to you by drawdown providers. These funds should give returns similar to bank or building society deposits. While you won’t see exceptional growth should the stock market take off, you should not unduly suffer during a downturn.
After taking your tax free lump sum you can, at any point, start taking income from the fund. You can either do this by drawing it down from the Drawdown pension itself (see slow start annuity), or you can use the whole of the fund to take a conventional Pension Annuity.
Current rules dictate that if the Drawdown fund is still in operation when you reach age 75, you must use the fund to purchase a pension life annuity.
We are also able to offer you a Drawdown contract which would offer you 100% protection of your capital and a guaranteed return if you are willing to leave your fund completely untouched for a set term. The mimimum term is three years or you could chose any other term as long at the maturity point was not after your 75th birthday. For more information and quotes on such a contract please contact us on 0875 83 87 811.
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Tax Free Cash - How Can We Help |
| Whilst we hope that we have explained this area in detail for you, we do understand that you may want to talk to a real person about this. Please call us on 0845 83 87 811.
We will look at your existing pension arrangements and see what options are available to you. It may be that your existing provider will offer you a drawdown option; you may have to transfer; your fund size may exclude certain providers from offering you a drawdown contract..
We will provide you with a report that details all of your options, while indicating which option we believe is closest to the needs you have described to us.
All other things being equal, we will order products using the following criteria: cheapest on-going costs, policy features, provider financial strength and reputation.
Upon receiving your instruction, we will contact your existing pension provider to obtain details of your current pension contract.
We will ask you to give us written authority to speak to your existing pension provider. This is because we can then see if your pension contract has any special conditions, which could indicate that it is best for you to stay with your existing provider. Without this written authority, your pension provider will not be able to give us specific information about your pension.
We can of course obtain quotes purely based upon the information you provide. In such cases we are sure you understand that we could not be held responsible if you moved away from a pension that offered enhanced rates or guarantees.
We will then need to get an understanding of the features you require from your pension. Obtaining this information from you should not take more than a few minutes.
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Tax Free Cash - What You Need to Decide |
| The most important decision you will need to make is whether it is right to take a tax free lump sum from your pension fund before your retirement age.
Once you have made that decision, we are more than willing to help you.
There are, of course, a number of benefits and risks in taking this course of action and we will highlight them below.
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Opportunities |
| The sum is paid tax free for you to spend as you wish.
By keeping your pension invested, you have the opportunity to manage your investment options until you want to purchase an annuity. A good investment strategy could not only replace the amount withdrawn from the fund, but even grow the fund.
At the point you want to take an income, you have a number of options, including full pension annuity or taking an income from the Drawdown fund.
Even if you don’t want any income at the point you take your lump sum, you could nevertheless take an income and use this monthly income to put into another personal pension. the advantage of this is that a personal pension is more tax efficent if you should die while it is still in place. You also have the potential to take another Tax Free Cash lump sum from funds in the personal pension.
If you die while the drawdown contract is in place, the fund will form part of your estate and will pass to your family. Depending on how your family use the fund it may attract a tax liability of 35%. With an Annuity, the fund is lost. This may be mitigated to a degree if an annuity with a guaranteed pension or partner’s pension is selected.
You can transfer the fund to a standard pension annuity at any point, but no later than age 75.
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Risks |
| Taking your pension lump sum early may mean that the amount taken is significantly lower than if you had left the pension invested until retirement age. For example, a pension fund growing a 3% per annum may pay a tax free lump sum at age 55 of £25,000. If the lump sum had been left invested, then in this scenario at age 65 the tax free lump sum would be £33,600.
Therefore you should only take your lump sum before retirement if it will make a significant change to your financial circumstances.
Like all pension funds, you are exposed to the movements in the financial markets. Your pension fund could go down as well as up.
If you are also taking a monthly income directly from the pension fund, you could seriously erode the value of the fund. You could even reach the point where the pension fund is completely exhausted. At this point any monthly income taken will stop.
By moving away from your current pension plan you could run the risk of losing some valuable benefits, such as guaranteed annuity rates.
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| The purpose of these notes is not to turn you away from a drawdown solution, but to make you fully aware of all the implications before you make an irreversible decision.
Drawdown can be an excellent solution for many people, and we have many clients on our books who have used it to make a major impact on their lives.
It is not however an ideal solution for everybody and you must ensure you fully understand all the risks before taking an irreversable decision.
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