Do knee-jerk lump sum pension withdrawals make sense?

The issue

Once again we are in the season of ‘Budget madness’. This season will run all the way until 26 November 2025 when we will all know what treats are in store for us. One rumour which is doing the rounds again is the removal of the 25% tax-free pension lump sum. This could be seen as attractive to the current Government because:

1. It hurts the rich.
2. It stops people enjoying a tax-free extraction which, with further planning, could remove value from the IHT net (pensions are subject to IHT from 6 April 2027).
3. It would be relatively easy to implement.

One disadvantage would be that quite a few, not very rich people, would be hit too and so the policy could be generally unpopular. This could be countered by putting a tax-free limit of say £50,000 on the lump sum, rather than the current £268,275.

These rumours are leading to a scramble to take out tax-free lump sums before the Budget. People are hoping that even this Government will not be so unsporting as to impose a retrospective cap on such a lump sum.

Does this make sense?

Many commentators are urging caution here. They point to the dramatic impact of taking a large sum outside of a tax-free environment, where it would otherwise grow at a much faster rate. This is all true but the withdrawal of the tax-free allowance is also a truly horrible prospect. Withdrawals of the lump sum can be put to good use, even if the reason for making the withdrawal (withdrawal of the relief) does not transpire. The following are good things to consider doing:

1. Blow it all and have fun! There will be no IHT on money you spend (on yourself) therefore any fun will be sponsored by the Government at a rate of 40%.
2. Give funds to the kids and hope to survive seven years.
3. Use it as a fund to stick £40,000 a year (as a couple) into ISAs (although they may have a nibble at these too). This might be a slow-burn to get back into a tax-free environment, but you will still have achieved the tax-free extraction.
4. Give it to the kids so that they can afford to make more pension contributions themselves out of their earned income (although will they want to if they think benefits are being stripped away?).
5. Buy a house in a far away land with a nice pension tax treaty clause, go and live there and then extract the rest of the pension tax-free (hope the rules do not change here too!).

WSM’s view

Even before IHT on pensions was announced we often thought that it was a good idea to extract the lump sum and then do some tax-efficient planning with it. Even before IHT is imposed, beneficiaries will still face a hefty income tax charge on extracting pension funds after the death of the (aged over 75 years) member. With a fair wind, it will often be possible to avoid the income tax charge through the extraction of a lump sum, and then also to avoid an IHT charge on the extracted funds by either ensuring that they are spent, or given away more than seven years before death. People shouldn’t necessarily be withdrawing their lump sums because of the looming budget but they may want to ask themselves whether they should be doing it anyway…