A lump-sum payment refers to situations where an amount of money is paid all at once, rather than in instalments. It's most often used in reference to pensions, where you have the opportunity of taking a lump-sum payment from your pension company or smaller payments over an extended period of time – or usually, a combination of both. Lump-sum payments can vary in amount and terms and should be decided based on your financial circumstances.
How do lump-sums work in pensions?
Lump-sum payments in pension schemes often occur at the beginning of the withdrawal period. Different pension schemes have different rules which dictate what percentage of your pension you're able to take as a lump-sum, with many schemes capping at around 25%, but some going beyond this. It is important to remember that taking a lump-sum reduces your remaining pension's overall value, so your regular payments will be lower. For some, this still works out to be an economically sound move because of the length of time the pension will be drawn for or any immediate needs or expenses that the lump-sum can be put towards.
Lump-sum vs. annuity
Technically, an annuity is a product rather than a payment. You buy an annuity from your pension provider, and, in exchange, they guarantee you a regular income for the remainder of your life. The amount you receive will depend on the size of your pension pot, including whether you withdraw a lump-sum payment at the beginning, as well as other factors, such as health and life expectancy. Many people choose to combine the lump-sum and annuity options by taking out up to 25% of their pension at the beginning as a lump-sum and investing the rest into a lifetime annuity.
What are the advantages of lump-sum payments?
Lump-sum payments are tax-free up to 25%, whereas an annuity can be taxed as income – so many people will opt to take the maximum amount as a lump-sum to save money. It also provides you with an instant cash injection, which can be particularly useful if you have a mortgage or bills to pay off or if you have a large upcoming expense.
What are the disadvantages of lump-sum payments?
Lump-sum payments do reduce the amount that you can then spend on your annuity, which will, in turn, reduce the regular payments that you receive. This can sometimes cause difficulties for those with smaller pension pots, so it's vital to assess annuity rates when making the decision about whether to take a lump-sum payment and how much to take.
What are the tax implications of lump-sum payments?
If you're taking a lump-sum payment of up to 25% from your pension pot at the beginning of your withdrawal period, it will be exempt from tax regardless of the cash amount you receive. However, this may have an impact on your overall income from the year and, if it's a significant amount, could potentially push some of your earnings or other income into a higher tax bracket. As such, it is always a good idea to talk to a financial advisor or an accountant about any amount you intend to withdraw to ensure you don't end up at a disadvantage.
Some pension schemes, such as defined contribution pension schemes, allow you to withdraw differing amounts from your pension pot at any point during your withdrawal period, rather than just at the start. After your initial lump-sum, these withdrawals are categorised as taxable income, so you may have to pay a percentage of the money you receive towards tax.
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