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Take Your 25% Tax Free Lump Sum, Or Not?? Blog 171

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Take Your 25% Tax Free Lump Sum, Or Not?? Blog 171

19th April 2021

Paddy Delaney

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Conventional wisdom suggests when we want to take our pension benefits, we should absolutely take our 25% tax free lump sum from pensions. Provided of course that this is an option for us, the mighty ‘conventional wisdom’ tells us that it is without doubt the right thing to do. I have always felt the same – take the 25% tax free (it’s the only tax free cash you’ll get!) and run. It was only when posed with a specific question from one of our Tribe Members as to the real merits or not of this piece of conventional wisdom that I’m now validating (or very possibly critiquing!).

The Low-Down

The question was posed with the following logic (I’m paraphrasing and applying my usual verbosity here!):

  • When we get to retirement, most pension holders take the 25% Tax Free Lump Sum and stick it in the bank or otherwise invest it in a taxable structure
  • Having done that provided they are over 60 they then are obliged to take 4% per year income from the remaining 75% (which would be in an AMRF/ARF) at a potentially low tax rate. See Blog 147 from last year for full low-down on ARFs/Draw-Down
  • In so doing I have just taken 25% out of a structure on which any gains are tax free, and stuck it on deposit account or into a personal investment on which any gains will be taxed at 33% (CGT) or Exit Tax (41%).
  • Unless I have actual need at point of retirement for the 25% Tax Free Lump Sum might it better to that 25% portion in the pension structure and draw down the pot at per the 4% and 5% annual income (minimum distribution) rules

On initial reading it certainly makes for an interesting question, and seeing as it is challenging a bed-rock of conventional wisdom in financial planning I was intrigued. On further reflection it will be fair to say that the overall outcome will depend on many variables, some of which are within our control (when we access pots, how we invest it, what we do or don’t do with the 25% if we do take it out, what level of other income sources we have, what rate we draw-down on the ARF etc). And same are outside our control (tax rates, interest rates, return from underlying funds, how long we live, tax and pension rules!). So in a way, much like all aspects of money, if you are looking for a concrete outcome or 100% certainty you are barking up the wrong tree.

Blog 102

Back in Feb 2019 I researched and wrote a piece (Blog 102) about ‘Saving into a Pension versus saving into a Deposit Account’. In it I analysed the performance potential and tax potential of both routes and putting them head to head to see which was a winner. It won’t surprise you dear reader to know that the pension route won by more lengths than the mighty Rachel Blackmore did in the Grand National recently (What a win that was!). In that piece I worked on some illustrative assumptions which I’m applying here too:

  • You will reach retirement at 65 with a pension pot of €1m
  • You can get 25% of your pot as a tax efficient lump sum; the first €200k tax free, the next €50k in this case at 20%
  • We assume your ARF/AMRF are treated the same in draw-down so refer to it as ARF only
  • You pay 1.8% annual fees on your ARF
  • Other than State Pension you have zero other income
  • Inheritance Tax (CAT) rules remain as they are where if you die with an ARF a new ARF is set up in your spouses name and he/she receives the income
  • Standard CAT rate of 33% applies to cash your kids might end up receive from you while the CAT rate on ARFs passed to adult kids over 21 years of age is 30%
  • You live to 90 years of age – at which point any cash passes to your adult kids

Below we dig into the two routes, simulating the two options around taking your Tax Free Lump Sum or not, as best we can based on the above – hope it is presented some bit clearly!

Option A – The ‘Conventional Wisdom Route’

You take 25% Tax Free Lump Sum (up to max €200,000) and then an additional €50k at 20% tax, meaning €250,000 in the hand and you have paid €10,000 tax. We’ll assume that you use €50k of the cash to buy yourself or a loved-one something nice such as a holiday/gift/car etc. You bank the rest in a deposit account for use over the next 10-15 years. Interest rates are on the floor but you manage to secure 1% per year net from a State Savings Account.

As confirmed earlier, after taking the Tax Free Lump Sum you then place the remaining €740,000 in the Approved Retirement Fund (ARF). Of course, you could have opted to buy an Annuity instead but you’ve seen the terribly poor annuity rates and decide to take the only sensible option of an ARF. So we’ll assume you invest the €740k in an Approved Retirement Fund and then draw 5% per year. Of course, as you are 65, you are only obliged to take 4% per year, but you reckon that’s only faffing about so you go with the €37,000 (5% of start pot) income thanks very much! Oh, we also assume that, as per Pension rules here that if your pot increases or decreases that your income increases or decreases along that 5% of pot trend. We built this into the by ensuring that when your pot rises or falls by a significant level that your draw-down will follow-suit (we applied Guardrails of 15% + or – will shift your income draw-down by + or – 15%).

How Much Did You Get Out?!

We’ve applied actual real-world analysis here to help us, using a prudent and proven 75% Diversified Equity and 25% Diversified Bond portfolio of specific make-up, and paying 1.8% annual fee. Using actual market returns over the past 100-odd years we can see that the outcome for the ARF was very favourable indeed based on the above.

Running all monthly rolling periods of the above portfolio paying the above fee and above draw-down strategy. The Median outcome say you draw lifetime income (between 65 and 90!) of €1.22m over the course of the 25 years of your retirement! Congrats, you got more out than you put in! As well as that, the Median outcome saw your ARF being still valued at €1.3m in nominal terms. See graph below.

A well invested €740k pot gave Median Outcome of €1.2m total income and pot value of €1.3m after 25 years of use!

All sounds very lovely but what was the Net Income from the ARF in this scenario please….

Importantly, if you are over 65 (which you are in this scenario!) and are married or in a civil partnership (which you are in this scenario!) you can earn €36,000 per year Gross before paying income tax. As you are entitled to the State Pension (€243 Gross) and your partner is classed as a ‘Qualified Dependant’ (€162 Gross), you have a joint income of €21,080 per year from State Pension.

Once you take your Tax Free Lump Sum and start taking the 5% from your ARF (€37,000) you now have a total income of €58,080. As a result of Nil PRSI, Tax Band, Joint Assessment and Tax Credits your total tax liability on that combined income is in the region of €9,800 per year. Your effective tax rate therefore on all incomes is approximately 17%.

Applying that the real-world retirement life-span income of €1.2m, we can say with a fair degree of certainty that you ‘netted’ €996,000 of that income from your €740k ARF.

In Summary, from the ‘Conventional Wisdom’ Route you secured:

  • €250k Tax Free Lump Sum Cash (probably little in way of financial returns from deposit here but hopefully some decent ‘returns on life’ with the cash money and doing fun things!)
  • €1m Income over the course of your retirement
  • Your Estate benefited from the proceeds of your ARF to the tune of €1.3m

Net outcome here was a total ‘windfall’ to you and others of €2.55m (all from a €740k ARF thanks very much!). Importantly, €1.25m of it, you got to enjoy, the balance going to your estate!

Option B – The ‘UnConventional Wisdom Route’!

To clarify, here you decide not to take your 25% Tax Free Lump Sum and instead move the full €1m straight to ARF. All else remains the same as in Option A above.

So you invest €1m in the Approved Retirement Fund (ARF). So we’ll assume you then draw 5% per year. Again, we built in the same Guardrails of 15% + or – in fund value will shift your income draw-down by – or + 15%. Obvious to state that given you have a larger ARF to begin with than in Option A, your 5% equates to €50k Gross Income per year at outset.

We’ve again applied the real-world 75% Diversified Equity and 25% Diversified Bond portfolio paying 1.8% annual fee. Running all monthly rolling periods of the above portfolio paying the above fee and above draw-down strategy. The Median outcome say you draw lifetime income (between 65 and 90!) of €1.64m over the course of the 25 year retirement! The Median outcome saw your ARF being still valued at €1.8m in nominal terms, per updated graph below!

So, what was the Net Income from the ARF in this scenario…

Because you didn’t take the Tax Free Lump Sum and instead went taking 5% from your €1m ARF (€50,000) you now have a total income including State Pensions of €71,080. As a result of Nil PRSI, Tax Band, Joint Assessment and Tax Credits your total tax liability on that combined income is in the region of €16k per year. Your effective tax rate therefore on all incomes is approximately 23%. While higher than Option A is still sounds pretty reasonable.

Applying that to the total retirement life-span income of €1.64m, your ‘Net’ income was €1.26m from your €1m ARF, not to mention the sum of €1.8m you leave to your estate from that same ARF.

In Summary, from the ‘UnConventional Wisdom’ Route you secured:

  • €1.26m Net Income over the course of your retirement
  • Your Estate benefited from the proceeds of your ARF to the tune of €1.8m

Net outcome here was a total payout to you and your estate of €3m. Worth noting of course that in this scenario of 5% draw-down and the portfolio and tax rates, only which €1.26m of that €3m actually went to you!

So, Is The Conventional Route The Best Route?

It’s actually quite interesting (in my view at least!). In both routes you netted €1.2m into your hand over the course of your retirement – the Conventional Route giving you a nice cash injection which you may or may not actually need or want at the point of draw-down!

Another interesting point based on the above scenario, is by not taking the Tax Free Lump Sum, historically speaking at least, you left a larger ARF to your beneficiaries. This stands to reason of course as by not taking the Tax Free Lump Sum you are starting off with an investment in your ARF that is 25% larger, and it will grow tax free for 25 years!

By taking the 25% Tax Free Lump Sum you are reducing the ARF income by 25% Gross but only by 21% in Net after Tax terms. We typically take the Tax Free Lump Sum in order to get what we are entitled to (tax free money!). We also do it because it has been our expectation all along, and have been preparing for this from the moment that our retirement benefits came into focus for us!

In the above scenario we can say that if you had other forms of income in retirement that the effective tax rate will be different, or we got 20th or indeed 80th percetile returns over the 25 years, it would be a very different outcome. Of course it would. As it would be if, instead of sticking the €250k Tax Free Lump Sum on deposit, we invested it and had achieved 10% per year growth for the 25 years – we’d have a pot of €2.7m! All massive variables that in a round way make the entire question null and void!

Having said that, the comparison certainly shows that there are pros and cons to the approach of taking the 25% Tax Free Lump Sum, and the majority of us will continue to aim to do so – but some may not, and the above analysis, thanks to our dear Tribe Member for asking the question, might just be a helpful guide in recognising that UnConventional Wisdom might actually be a prudent form of wisdom!

Thanks for Reading!

Paddy.

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