Today’s pension income options are greater than ever. Gone is the need to buy an annuity and accept a regular income each month. Instead, you have far more control over your pension fund, including where it is invested, how much income you can take from it, and what happens to it after you die. If you’re looking for lots of control, then pension drawdown might be the way to go.
It’s riskier than buying an annuity but if you want to take money out of your pension on an ad hoc basis, pension drawdown offers the most flexibility.
What is pension drawdown?
Pension drawdown is fairly straightforward. It allows you to take some or all of the money you’ve saved into your pension pot throughout your working life and reinvest it into a special income drawdown plan.
Over time you can take money from this plan – known as pension drawdown – and you can take as much or as little as you like. Depending on how much you take, you’ll have to pay income tax. However, unlike with an annuity, the rest of the fund remains invested in the stock market, meaning it can continue to grow in value (although it’s worth remembering that the value of funds can fall as well).
There are two types of pension drawdown plan:
Flexi-access drawdown – Introduced in April 2015, this type of plan transformed how pension funds could be used to fund retirement. In one fell swoop, it removed any limits to how much money you can take as pension drawdown at any one time. If you’re just considering your pension options or have retired in the last couple of years, then flexi-access drawdown is open to you.
Capped drawdown – It was possible to take advantage of pension drawdown prior to April 2015, but there were limits to how much money you could take out and the plans and tax rules are more complex. If you’re still on a capped drawdown, it may be possible to move your fund to a flexi-access drawdown plan. Speak to an independent financial advisor for guidance on what’s best for you.
In any case, you can also take up to 25% of your pension pot as a tax-free lump sum, itself a form of pension drawdown. Any money you subsequently take out after the 25% is subject to income tax.
Some providers of pension drawdown income plans allow you to pick the fund’s investments. This should also lower the high fees a pension drawdown income plan can attract if you let an advisor pick investments for you. By picking certain types of funds, you have the flexibility of managing your risk appetite and the type of income level you are aiming for.
You’ll need to regularly review the performance of your pension drawdown income plan with an independent financial advisor to ensure you’re getting the best return possible.
Save more for retirement with a private pension top-up. Read our Private pension top-up guide on how to increase pension contributions and tax relief.
How much pension drawdown can you take?
While the first 25% is tax-free, any subsequent income you take is subject to income tax thresholds. Assuming you have no other income – which includes State Pension – the thresholds are:
- The first £11,850 is tax-free and forms part of your personal tax allowance;
- The next £34,500 you withdraw is taxed at 20%;
- Everything between £46,350 and £150,000 is taxed at 40%;
- And you’ll pay 45% tax on everything above £150,000.
For example, if you took out £40,000 from your pension drawdown income plan and had no other income – and this includes other pensions – you would be liable to pay tax of £5,630.
Bear in mind the weekly basic State Pension of £125.95 will eat into your tax free allowance as it pays £6,549.40 each year, while the full State Pension of £164.35 will mean you’d have earnings of £8,575.55 per year. These will affect how much tax you pay on any pension drawdown you make.
Find out more about the State Pension and how much you will get.
Taking out lump sums can move you into a higher tax bracket without you being aware, leading to a higher tax bill. It’s best to keep an eye on the amount you have withdrawn within the tax year, along with other income, to ensure you don’t accidently breach a tax threshold and end up pay far more tax than needed. For example, you might be better taking out £25,000 in January and a further £25,000 in July as you’d only liable for 20% tax on £13,150 in each financial year – paying a total of £5,260 in tax. If you took out £50,000 in January (so, the entire amount in one financial year) you’d pay £8,360 in tax – making you £3,100 worse off.
What happens with pension drawdown when you die
Previously, remaining pension funds were subject to a 55% tax before the remainder was passed on as an inheritance. Today, the entire fund is tax-free when it is inherited and can be passed onto anyone you nominate. They can either take the entire fund as a single tax-free lump sum or continue to drawdown from it as a tax-free income. This only applies if you are aged 75 or less when you die. If you are older than 75, whoever inherits your pension fund will pay inheritance tax at their marginal rate of tax. Make sure you fill in the ‘Expression of Wish’ form when you set up the fund as it allows you to nominate who will inherit the fund. Previously this was limited to dependents such as your children.
Saving into a pension while in a pension drawdown income plan
With pension drawdown, as soon as you start a pension drawdown plan the amount you can save each year into a pension reduces by 90% if you go over the tax-free threshold. It falls from the £40,000 annual pension allowance to just £4,000, but this is only triggered when you take more than 25% from the fund. If you take a 25% lump sum tax-free and no more, you can still invest in a pension fund up to £40,000. As soon as you withdraw more than 25% from the fund, the amount you can invest falls to £4,000.
What are the alternatives to pension drawdown
Annunities – These fell a little out of favour a few years ago and used to be the only way you could earn an income from a personal pension. Previously you had to purchase an annuity, which swapped your pension fund for a guaranteed income for the rest of your life. How much you got depended on your lifestyle and health, as well as options such as linking income to inflation.
The benefit is a guaranteed income for the rest of your life. If you live long past retirement age then you could get more overall income than your pension fund had been worth. There’s also the certainty of regular income, making financial planning easier.
On the downside, annunities are quite limited. You can’t change your mind once you’ve purchased an annuity, and when you die you can’t pass on your annuity. However, recent government changes could see future annuities becoming more flexible, including the ability to make changes to the amount of regular income you get and even pass on some of the fund when you die.
Lump sums – As well as the 25% lump sum you can take out tax-free from your pension fund, you can withdraw lump sums on an irregular basis and not have to place the withdrawn sum into a pension drawdown income plan. This means that the money doesn’t remain invested in a fund that could see rises (and falls), and after the initial 25%, anything you withdraw is subject to income tax. It’s known as taking uncrystallised funds pension lump sums (UFPLS) and is similar to pension income drawdown, just without your find being invested in the stock market.
Should you choose a pension drawdown income plan?
Everyone’s needs are different, and you should get independent financial advice from an IFA. Your individual circumstances and attitude to risk will determine what is the right approach for you.
Consider pension drawdown if:
- You’re happy to keep pension fund invested in stocks and shares, along with the risk that the value of the fund could fall as well as rise and you might not get back the full value you originally invest;
- You’re likely to withdraw funds on an ad hoc basis with different amounts each year, and value flexible access to your money;
- You want the reassurance that the fund will be part of your estate and can be inherited tax-free by anyone you choose;
- You’re comfortable with managing your tax liabilities.
Think twice about pension drawdown if:
- You prefer the security of a guaranteed monthly or annual income such as that offered by an annuity;
- Prefer to minimise the risk to the value of your fund that keeping it invested can pose;
- Don’t want to pay high charges to operate a pension income drawdown plan that some plans incur;
- You want to ensure you don’t run out of money by withdrawing too much money early on in the plan. This can be a real challenge, especially if you live longer than you expected, take out too much money early on or don’t modify withdrawal amounts in line with fund performance.
It’s important that a pension withdraw income plan is reviewed regularly with a financial advisor, and that you adjust the amount you are withdrawing in line with the performance of the plan.
How do I start a pension drawdown?
Getting started with a pension drawdown income plan is fairly straightforward, though independent financial advice is a necessity. Company pensions are mostly off limits, however, as few, if any, will offer the ability to drawdown. In these cases, it can be worth considering transferring the fund to a new fund that does allow this.
For personal and private pensions, you can shop around when you retire and invest your fund into one of the pension drawdown income plans on the market. Alternatively, your pension pot provider may offer you the option when you retire.
You can also think about starting a Self-invested Personal Pension (SiPP) into which you transfer all your pension pot and then activate the pension drawdown function. Speak to a financial adviser to get the best advice for you.
