The Lemon Fool

At retirement date let's assume the basic options for a DB (final salary) pension are:

A) £150k cash plus indexed £22,500 per annum (ie lump sum option taken)
B) £30,000 per annum indexed (lump sum option NOT taken)

For option A I am certain of the tax treatment, which is no tax on the 150k and all of the 22,500 taxed at recipient's marginal rate

For option B, I am uncertain of the tax treatment. Is all 30,000 taxed at the marginal rate, or is only 75% of this subject to income tax at marginal rate?


I do believe that if you receive £2500 a month from a DC SIPP (for 30k pa), and have not taken a tax free lump sum, only 75% of the monthly payment is taxable, but I don't know if there is a direct read over to DB.

Thanks for any assistance

eventide wrote:For option B, I am uncertain of the tax treatment. Is all 30,000 taxed at the marginal rate, or is only 75% of this subject to income tax at marginal rate?

I don't believe any changes were made to the taxation of defined benefit payments when the flexible drawdown rules were introduced not so many years ago. So it's all taxable.

B would be taxed as income. It's still the better deal unless you have an extremely short life expectancy!

AWOL wrote:B would be taxed as income. It's still the better deal unless you have an extremely short life expectancy!

I agree with that if your marginal tax rate is 20% and normal LE, it is a cloudier after-tax NPV calculation if you breach the 40% band taking the full DB as income. But if 25% of this DB income were outwith the calculation that would be an even greater case for B. I expect Alaric is correct, that all of it is taxable

Option B...taxed as though your income is £30k.

eventide wrote:At retirement date let's assume the basic options for a DB (final salary) pension are:

A) £150k cash plus indexed £22,500 per annum (ie lump sum option taken)
B) £30,000 per annum indexed (lump sum option NOT taken)

For option A I am certain of the tax treatment, which is no tax on the 150k and all of the 22,500 taxed at recipient's marginal rate

For option B, I am uncertain of the tax treatment. Is all 30,000 taxed at the marginal rate, or is only 75% of this subject to income tax at marginal rate?


I do believe that if you receive £2500 a month from a DC SIPP (for 30k pa), and have not taken a tax free lump sum, only 75% of the monthly payment is taxable, but I don't know if there is a direct read over to DB.

Thanks for any assistance

Option B would be taxed at your marginal rate.

The equivalent for the DC pension in drawdown would be to crystallised the whole DC pension but not take the 25% tax free lump sum (which would admittedly be odd behaviour). Everything you subsequently drew down would then be taxed at your marginal rate.

The idea that you might only have to pay tax at your marginal rate on 75% probably comes from thinking about taking a DC pension using UFPLS. With UFPLS you leave the DC pension uncrystallised and take the pension in chunks with each chunk consisting of a 25% tax free amount and the remaining 75% being taxed at your marginal rate.
Note. Though this is still taking the tax free lump sum - it is just doing it slowly over time. Hence it isn't equivalent to deciding not to take the DB tax free lump sum.

For a DC pension taking the 25% tax free lump sum is pretty much a no brainer. With a DB pension though there may be good reason NOT to take the full 25% tax free lump sum. This is because most DB pensions either come as standard with no tax free lump sum or with a tax free lump sum which is less than the allowable 25%. To obtain a 25% tax free lump sum with such a DB pension you therefore have to give up some annual pension to convert it into the money for the lump sum - this process is known as commutation. Unfortunately the commutation rate - amount of tax free cash for each £1 of annual pension given up - is usually pretty bad. Hence it may well be better to forego the 25% tax free lump sum (unless of course you have debts to pay off or don't expect to live that long in which case taking the tax free lump sum with even a poor commutation rate might make sense).

In your example it looks like the commutation rate is 20 (150,000 / (30,000 - 22,500)) which is higher than some (Public sector pensions tend to have commutation rates of 12) but not particularly generous.

Might be worth bearing in mind that the income you forego - £7,500 is gross. You'd presumably pay 20% tax on that so you miss out on £6k cash for the rest of your pension to get £150k cash up front.

On a simplistic basis the break even point is 25 years (when the tax free cash gain is superseded by the extra annual payments). At some point I need to model what would happen if the tax free lump sum were invested and how that effects the payoff.

I'm working on the basis of taking tax free cash to front load my pension. I'd rather have more money at the start of the pension when I'm more likely to get benefit from it. My energy and need for money are likely to have diminished 15-20 years after retiring

bucklb wrote:I'm working on the basis of taking tax free cash to front load my pension.

There are boards on this site where the conversation is expected to be about using a lump sum invested in shares with higher than average dividend yields. You are at risk of market value and dividend fluctuations, but when the risks come off, the income would be higher than taking all the benefits in pension annuity form, plus there should be some left over for your heirs.

Alaric wrote:

bucklb wrote:I'm working on the basis of taking tax free cash to front load my pension.

There are boards on this site where the conversation is expected to be about using a lump sum invested in shares with higher than average dividend yields. You are at risk of market value and dividend fluctuations, but when the risks come off, the income would be higher than taking all the benefits in pension annuity form, plus there should be some left over for your heirs.

Or indeed other strategies not involving higher than average dividend yields.

Another thing to consider is how your DB scheme handles surviving spouse pensions payments - if this is applicable in your case.
In some DB schemes the survivors pension is reduced by taking a lump sum, in other schemes it isn't.
You may want to consider the amount your spouse gets to live on following your untimely demise as part of your calculation.

Thank you to every one that has commented. My original question was whether the DB annual cashflow was fully taxable if no lump sum was taken, or whether only 75% of it would be taxable. I believe that question is now answered as "it is fully taxable" and I am grateful for the responses.