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Why you would take a PCLS

There are many reasons why you may wish to consider taking out a pension commencement lump sum (tax free cash as was) from your pension fund. The world cruise, perhaps, or a new car might spring to mind first but they aren't necessarily the right reasons! Many people may find themselves with a mortgage that still has a few years left to run when they reach retirement. Taking a PCLS out of your pension fund to pay off the mortgage immediately would save on interest charges and could actually increase your disposable income in retirement.

Alternatively, you could use the lump sum itself to boost your income in retirement by investing it. Remember that your pension benefits are potentially taxable. Therefore, you may wish to use the tax-free lump sum to buy a purchased life annuity that offers tax advantages over a standard pension annuity. With the former, most of the income is treated as a return of capital and, therefore, is tax free with the remaining interest portion being taxed as savings income at 20% only. However, if the annuitant is a higher rate taxpayer, there will be an additional 20% tax liability, non-taxpayers can reclaim the tax deducted at source and 10% taxpayers can reclaim the tax overpaid.

This key difference in the taxation of pension annuities and purchased life annuities means that it may make sense to take the PCLS and use it to buy a purchased life annuity in order to maximise income at retirement.

When you come to retire and take your pension, your pension income is taxable as "earned income". Defined benefit occupational pensions are paid with basic rate tax deducted at source. Your personal tax allowance rises at age 65 and again at age 75, subject to your overall level of income, allowing you to keep more of your money. However, some pensioners still end up having to tackle self-assessment tax returns and pay higher rate tax on their pensions. From 6 April 2007 retirement annuities have also been paid under the PAYE (Pay As You Earn) system.