THE UNIVERSITY OF DUBLIN TRINITY COLLEGE PENSION SCHEME CONSIDERATIONS WHEN TAKING A TAX-FREE LUMP SUM

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1 THE UNIVERSITY OF DUBLIN TRINITY COLLEGE PENSION SCHEME CONSIDERATIONS WHEN TAKING A TAX-FREE LUMP SUM

2 WHAT YOU SHOULD CONSIDER WHEN DECIDING TO EXCHANGE PENSION FOR A TAX-FREE LUMP SUM If you are close to retirement, it may be time to start thinking about whether or not you should exchange part of your pension for a tax-free lump sum. The maximum amount of tax-free cash that you can take is 1.5 times your Final Remuneration, provided you have at least 20 years of service with the College. A smaller amount will apply if you take cash from the pension scheme of a former employer or if you have less than 20 years of service. The maximum tax-free lump sum that can be taken at retirement is subject to an overall lifetime limit of 200,000. Higher amounts will be taxed at the standard rate (currently 20%) and amounts in excess of 575,000 will be liable to tax at your marginal rate. The rate at which your pension can be exchanged for a tax-free lump sum varies according to your sex and your age. At normal retirement age (i.e. 30th September following your 65th birthday), a male will currently get 9 for each 1 p.a. pension he exchanges for a cash lump sum and a female will get 9.80 for each 1 p.a. of pension she exchanges. The different rates for males and females reflect the different life expectancies of males and females at age 65. Of course, individual circumstances are different and there is no substitute for talking through the issues with an Independent Financial Advisor; however, to make sure you are aware of what you should consider, here are some of the issues involved: 1 The main attraction of the lump sum is that it is tax-free. All pensions paid are taxed as income - obviously, this is more important if your marginal rate of tax will be 41% than if it will be 20%. The tax-free lump sum tends to be more attractive to those on the higher marginal tax rate. 2 If you are married, any exchange of pension for cash will reduce the pension payable to your spouse in the event of your death. This is because your spouse s pension is 2/3rds of your own pension after any cash lump sum is taken; therefore, a tax-free lump sum may be more attractive to a single rather than a married person. 3 By exchanging some of your pension for cash you give up the possibility of receiving increases on the amount of pension exchanged. The Board of the College currently follows public sector practice when reviewing the pensions of retired members. Any increases are granted on an ex-gratia basis, i.e. they are provided by the College and do not represent a liability of the Scheme. These discretionary increases are applied to your pension in payment, i.e. your pension after any amount exchanged for a tax-free lump sum. 4 Is the lump sum received more valuable than the cost of securing the amount of pension exchanged? One way of judging the attractiveness of the lump sum option is by comparing the lump sum received with the cost of securing the amount of pension exchanged on the open market. This comparison will vary by individual and will be dependent on your age, sex and marital status. The comparison will also vary depending on when you retire as the notional pension you could purchase on the open market with your lump sum is affected by the cost of buying annuities. These depend on a number of factors such as life expectancy and long-term interest rates which are continuously changing. 1

3 The examples at the back of this document show the annuity that could be purchased by lump sum amounts. It is important to note that each individual s circumstances will differ and the examples are designed to give an indication of the effect of taking cash. It should also be stressed that using annuity rates is just one way of looking at the relative value of the lump sum option. In reality, most people who take a lump sum will not use it to purchase an annuity. Some may spend it, others may invest it conservatively (e.g., by placing it on deposit), while others may place it in riskier but potentially more rewarding investments such as company shares. Different investment approaches will produce returns which are higher or lower than the returns used in annuity costs, thus altering the comparative value of the pension and lump sum options. 5 Your current state of health. You need to consider whether or not you have any medical conditions which might decrease your life expectancy and, therefore, your future pension payments. 6 Your own circumstances. Deciding whether or not to take a lump sum depends very much on your individual circumstances. You may wish to consider what to do with the lump sum if you decide to take it, whether you can live comfortably on the remaining income you have, or if you would prefer to have a larger regular income for life. You should weigh up the pros and cons and make sure your choices suit your retirement objectives. Need more information? TCD Human Resources can arrange, on written request, for Mercer to provide you with an illustration of the effect of exchanging some of your expected pension for a tax-free lump sum. It is important to note that the option you choose at retirement is irrevocable once made; therefore, the College recommends that you take independent financial advice on a personal basis if you are in any doubt before making a decision to exchange some of your pension for a tax-free lump sum at retirement. 2

4 EXAMPLES The following examples are based on the tax rates for the 2011 tax year and annuity rates at October They exclude any other income you or your spouse may have such as pension benefits payable by the State or other pensions payable to you or your spouse. Example 1: Male Married Member Peter is almost 65 years old, he s married and retiring this month. He has been with the College for more than 40 years (he joined before 6 April 1995) and currently earns 60,000. He and his wife have no other taxable earnings. Lump sum 0 90,000 Annual pension 40,000 p.a. 30,000 p.a. Spouse s pension on Peter s death in retirement 26,667 p.a. 20,000 p.a. Notes n Pension is calculated at 40/60th of salary n Reduction in pension on taking a lump sum is calculated as 90,000/9 n Spouse s pension is 2/3rds of member pension n is 1.5 times salary After tax If Peter does not take a tax-free lump sum, he will have to pay tax on the additional pension received. Based on the 2011 tax rates, he will pay 20% tax and the Universal Social Charge (USC) on the additional pension received. By taking cash of 90,000 Peter would reduce his own pension by 7,300 after tax and his spouse s pension would also reduce. Value of the pension exchanged for lump sum By taking the lump sum option, it is important to understand the value of the pension exchanged for this tax-free lump sum. The cost of securing a pension of 7,300 per year on the open market would be approximately 149,000 for a 65 year old, based on current annuity rates. This pension will not increase in payment and has an attaching spouse s pension of 2/3rds payable on the member s death. These rates are subject to change and this value is based on bond yields as at October When it is considered that the pension of 7,300 p.a. has the potential to increase in payment whilst the annuity purchased will not, the value of the pension given up is significantly higher than the lump sum received of 90,000. 3

5 Example 2: Female Married Member Mary is almost 65 years old, she s married and retiring this month. She has been with the College for more than 40 years (she joined before 6 April 1995) and currently earns 60,000. She and her husband have no other taxable earnings. Lump sum 0 90,000 Annual pension 40,000 p.a. 30,816 p.a. Spouse s pension on Mary s death in retirement 26,667 p.a. 20,544 p.a. Notes n Pension is calculated at 40/60th of salary n Reduction in pension on taking a lump sum is calculated as 90,000/9.8 n Spouse s pension is 2/3rds of member pension n is 1.5 times salary After tax If Mary does not take a tax-free lump sum, she will have to pay tax on the additional pension. Based on the 2011 tax rates, she will pay 20% tax and the Universal Social Charge (USC) on the additional pension received. By taking cash of 90,000, Mary would reduce her own pension by 6,704 after tax and her spouse s pension would also reduce. Value of the pension exchanged for lump sum By taking the lump sum option, it is important to understand the value of the pension exchanged for this tax-free lump sum. The cost of securing a pension of 6,704 per year on the open market would be approximately 133,000 based on current annuity rates for a 65 year old. This pension will not increase in payment and has an attaching spouse s pension of 2/3rds payable on the member s death. These rates are subject to change and this value is based on bond yields as at October When it is considered that the Scheme pension of 6,704 p.a. has the potential to increase in payment whilst the annuity purchased will not, the value of the pension given up is significantly higher than the lump sum received of 90,000. 4

6 Example 3: Single Male Member Jack is almost 65 years old, he is single and retiring this month. He has been with the College for more than 40 years (he joined before 6 April 1995) and currently earns 75,000. He has no other taxable earnings. Lump sum 0 112,500 Annual pension 50,000 p.a. 37,500 p.a. By taking the lump sum of 112,500, Jack surrenders 12,500 of his own pension i.e. no spouse s pension applies. Jack is in a different marginal tax bracket and he would pay 41% tax and the Universal Social Charge (USC) on the extra pension of 12,500 if he does not take cash. In this case the comparison is quite different. If Jack does not take cash, his net additional pension after tax would be 6,500 p.a. The cost of purchasing a pension of 6,500 on the open market would be approximately 112,000 for a 65 year old. These rates are subject to change and this value is based on bond yields as at October As the Scheme pension of 6,500 p.a. has the potential to increase in payment whilst the annuity purchased would not, the value of the pension given up increases; however, this value and the tax-free lump sum received are significantly more comparable than that of Examples 1 and 2. This example demonstrates the relevance of marital status and the individual s marginal tax rate when comparing value on this basis. 5

7 Example 4: Single Female Member Jill is almost 65 years old, she s single and retiring this month. She has been with the College for more than 40 years (she joined before 6 April 1995) and currently earns 75,000. She has no other taxable earnings. Lump sum 0 112,500 Annual pension 50,000 p.a. 38,520 p.a. By taking the lump sum of 112,500, Jill surrenders 11,480 of her own pension i.e. no spouse s pension applies. Jill is in the higher marginal tax bracket and she would pay 41% and the Universal Social Charge (USC) on the extra pension of 11,480 if she does not take cash. If Jill does not take cash, her net additional pension after tax would be 5,969 p.a. The cost of purchasing a pension of 5,969 on the open market would be approximately 111,000 for a 65 year old. These rates are subject to change and this value is based on bond yields as at October As the Scheme pension of 5,969 p.a. has the potential to increase in payment whilst the annuity purchased would not, the value of the pension given up increases; however, this value and the tax-free lump sum received are significantly more comparable than that of Examples 1 and 2. This example demonstrates the relevance of marital status and the individual s marginal tax rate in the value comparison. 6