Smaller pension, larger lump sum

Dominic Thomas
Feb 2025 • 3 min read
To take a smaller pension and a larger lump sum
Most old-style pensions (Final Salary or Defined Benefits) tend to offer the ability to take a tax-free lump sum in exchange for a reduced pension income. Everyone is different, and advice should always be tailored to your personal circumstances and requirements. However, here I simply wish to outline the issues for consideration.
As an example, John is due to receive a pension of £23,195pa from his old employer. Alternatively, he could take a reduced pension of £17,583pa with a one-time tax-free lump sum of £117,224. That’s a difference of £5,612pa to his pension income (but with £117,224 ‘in the bank’).
If he were to die, the widows pension remains at 50% of the original pension (not always the case, but often) which is £11,597.50pa for the remainder of his spouse’s life.
Pension income is subject to income tax. In this case, his other pensions including the State pension (£11,500pa) would mean that he pays basic rate tax on total pension income (20%). In reality then, his gross income of £23,195 is really £18,556pa.
At face value, the tax-free lump sum is equivalent to 20.8 years’ worth of the lost income (£5,612pa). However, this is taxed income and really the net amount (after tax) lost is £4,489.60 which would be roughly 26 years of income in exchange for the tax-free lump sum of £117,224.
The same rate of inflation applies to whatever level of income is taken, but of course over time this will gradually compound.
If he were to die after five years of retirement, the pension would reduce by 50% whether he has taken the lump sum or not. However, if he hasn’t spent or used it, then the lump sum would have remained in his estate, and if invested, it should have grown. In the worst case scenario, if he and his spouse had both died shortly into retirement, there would be no ongoing income, but had he taken the lump sum (and not spent it) at least that would be left within his estate.
Naturally more income tax will be paid on the higher income and if he has a full State pension it would take around 10 years before he becomes a 40% taxpayer or 16 years if he takes the reduced income. We can obviously calculate the tax in more detail, but this is meant to be a simplified example.
Whilst it might be obvious, if the client has other taxable income, then taking the lump sum makes even more sense due to the reducing amount of net income received after basic rate, higher rate and potentially additional rate tax.
If you want to talk this through so that you get a better understanding of how this relates to your personal situation, please get in touch.