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Question: I would like to know what tax I would pay if I were to swap my final salary pension for a lump sum?
Answer: There are three main ways to trade in a final salary scheme for cash.
A final salary – or defined benefit – scheme promises a retirement income based on your salary and length of service. These pensions can be very valuable. They are common in the public sector, but now rare in the private sector.
I’ve unpicked the various options for accessing cash from a defined benefit scheme.
The first option is taking a tax-free cash lump sum. You can take your pension benefits from age 55 (rising to age 57 from April 2028). Some public sector schemes automatically pay an income plus a separate lump sum.
If this applies to you, you might be able to increase the total lump sum (subject to the maximum limits by exchanging some pension income for tax-free cash). Exchanging income for tax-free cash is the method most private sector schemes use.
How much cash you get in exchange depends on the scheme’s ‘commutation factor’. A 12:1 rate means giving up £1,000 of yearly income gets you £12,000 cash. A 30:1 rate would give you £30,000.
This trade-off can be difficult. You get tax-free cash upfront but a lower taxable income for life.
Remember, you could live for 30 years or more. The income you give up should increase each year and will become much more valuable over time.
The maximum tax-free cash is generally up to 25 per cent of the value of your pension benefits, capped at £268,275.
If your promised pension is very small, you may be able to take it all as cash under “trivial commutation” rules. Usually, all your pensions combined must be worth £30,000 or less, and you must be at least 55, rising to 57 from April 2028. Typically, 25 per cent is tax-free and 75 per cent is taxed as income.
The final option is transferring to a defined contribution pension, such as a SIPP (self-invested personal pension). From age 55, rising to 57, you can usually take up to 25 per cent tax-free and use the rest for taxable income through an annuity, drawdown or ad-hoc lump sums. This gives more flexibility, but also more responsibility.
The transfer value offered depends on the scheme and how much it expects it will cost to provide your income for life. Current investment conditions matter, including the yields and price of long-dated gilts used to match pension liabilities.
Transfer values have fallen since the start of the decade as gilt yields have risen. This means the price of these gilts has fallen, lowering the cost of providing a future secure pension income, although it has recently stabilised.
You would be giving up an almost guaranteed income for a pot you must manage yourself. That can suit some people, for example if they want flexibility, have a small pension, no dependants or limited life expectancy.
If your transfer value is £30,000 or more, you must pay a regulated financial adviser for a recommendation on whether to transfer and help facilitating the transfer. If this is your main pension, you are fit and healthy, and you have a partner, transferring is unlikely to be in your best interests.
If you have an unfunded public sector defined benefit scheme, you cannot transfer it to a defined contribution pension.
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