Taking an income from your pension can be confusing.
If you want to take up to 25% of your pension as a tax-free lump sum - subject to an overall limit of £268,275 in most cases - there are a number of different ways you can use your remaining pot to provide you with an income. One option available to you is income drawdown
What is income drawdown?
Income drawdown allows you to take a flexible income directly from your pension as and when you need it, whilst leaving your remaining pot invested. You can control the frequency and the amount of income you take to suit your needs.
You even have the ability to stop taking an income from your pension, either temporarily or permanently, in line with your requirements.
Funds held within a drawdown pension can also be used to purchase an annuity at any given point in the future, should you wish to do so.
There are two types of drawdown pensions:
- Capped drawdown
- Flexi-access drawdown
What is capped drawdown?
Capped drawdown pensions are subject to a limit on the maximum amount that can be drawn as income during a year. Those in capped drawdown retain their full annual allowance of £60,000 provided they stay within their income limit.
It is no longer possible to open a new capped drawdown pension. However, existing capped drawdown plans can continue and you may be able to add further pension funds to the plan.
The maximum income limit is 150% of the amount you would have received if you purchased a comparable lifetime annuity and is based on tables published by the Government Actuary’s Department.
The maximum income limit is reviewed every 3 years until the anniversary of entering drawdown after your 75th birthday, then annually thereafter.
Should the maximum income limit be exceeded, the plan will automatically be converted to a flexi-access drawdown pension.
You can also ask your capped drawdown provider to convert your plan to a flexi-access pension.
What is a flexi-access pension?
Flexi-access drawdown, previously known as flexible drawdown, is the term for a drawdown pension that allows you to take as much or as little income from your pot as you like with no maximum limit.
Any new income drawdown arrangements entered into since 6 April 2015 will automatically be flexi-access pensions.
Who can open a flexi-access pension?
Any individual who has reached the minimum pension age can move their pension fund to an income drawdown plan.
The minimum pension age is currently 55, although the government has stated that this will rise to 57 by 2028.
Not all pension products have the flexibility to provide income drawdown. This includes many workplace pensions arranged by employers.
Where this is the case, you will have to transfer your pension to an alternative plan – this can be with your current provider or a new provider.
Care must be taken when considering a transfer as some pensions offer guaranteed benefits or apply transfer charges that could make a move less advantageous.
How much tax will I pay on pension drawdown?
Other than the 25% tax-free lump sum, any withdrawals taken from your drawdown pension will be subject to income tax at your marginal rate. You can make use of your personal allowance, meaning that some or all of the income could potentially be taken tax-free.
Your pension provider will deduct tax from your withdrawals before paying them out to you.
They use the Pay As You Earn (PAYE) system to calculate the tax due, taking into account the personalised tax code that HMRC have provided.
The correct amount of tax is not always deducted from your pension withdrawals.
It is your responsibility to ensure the correct amount of tax is paid each year, so it may be appropriate to complete a self-assessment tax return.
It is likely that the first payment you receive from a drawdown plan will be taxed using an emergency tax code.
Using the emergency tax code can result in an overpayment of tax. The government has information available online to help you claim a refund of overpaid tax.
Can I still contribute to a pension?
Yes, you can still contribute to a pension. However, the maximum amount that you can contribute tax efficiently and receive tax relief on may reduce.
Individuals who have previously taken an income from a flexi-access drawdown plan will have a reduced maximum annual allowance of £10,000 for all future contributions to defined contribution pensions.
This is known as the money purchase annual allowance.
The money purchase annual allowance is only triggered once an income has been taken from the plan. Therefore, if you have a flexi-access drawdown pension that you have never taken any income from, you could still have the standard maximum annual allowance of £60,000.
The money purchase annual allowance rules do not apply to withdrawals from capped drawdown pensions.
Individuals with capped drawdown plans could therefore continue to be subject to the standard maximum annual allowance as long as withdrawals are kept within the maximum limit.
What can I invest in?
With a drawdown pension, you can choose to leave the funds invested. This provides a tax-efficient home for your pension fund until it is required to provide an income.
Most older pension products will only offer access to a limited selection of investments, so it is important to check with your provider. Remember, the value of investments and the income derived from them can fall as well as rise. You may not get back what you invest.
Whilst invested, any income and capital gains generated by the investments within your drawdown plan are not subject to tax.
It is important to be aware of the considerable risks inherent in certain investments.
Making the wrong decisions could have a detrimental impact on your pension and the income you receive from it over time.
How much does a draw down cost?
Drawdown pension charges tend to be higher than those of other pension income options. This is due to the greater level of administration required by the pension provider, as well as any additional costs relating to financial advice.
The investments you hold within your drawdown pension will also affect the cost of your plan.
This is because some providers can charge more to allow you to hold certain investments (such as commercial property) and some investments will have their own management charges which are separate from those of the pension provider (such as collective investment funds).
It is not uncommon for providers to levy additional charges for capped drawdown pensions. This is due to the additional administration undertaken as a result of the regular reviews of the maximum income limit.
What happens to my drawdown pension when I die?
Any remaining balance held within a drawdown pension on your death will usually not be subject to inheritance tax. It can be used by your nominated beneficiaries to provide flexible income by continuing with the drawdown pension.
Alternatively, they can withdraw the balance as a one-off lump sum or use it to provide a secure lifetime income by purchasing an annuity.
If you die before age 75, any income or lump sums taken by your beneficiaries will be tax free. If you die after age 75, any income or lump sums taken will be taxed at the recipient’s marginal rate of income tax.
By keeping the balance within a drawdown pension they will be retaining the relevant tax advantages of a pension.
They can also nominate their own beneficiaries to receive any remaining balance in a flexible manner on their death, these are known as successors.
Is a drawdown pension a good idea?
A drawdown pension could be a good idea if you require a flexible income from your pension and are comfortable taking some investment risk.
However, it is important to be aware that a drawdown pension does not provide a guaranteed income for life.
What this means is that you could run out of money if you withdraw too much income, you live longer than expected or your investments do not perform in line with your expectations.
It is for these reasons that drawdown requires a more ‘hands-on’ approach, where your level of income and the type of investments held needs to be kept under review throughout your retirement.
How can we help?
Guidance from an Adviser can help you choose the most suitable option for you by creating a personalised retirement plan, taking into account your personal circumstances and future aspirations.
Should a drawdown pension be appropriate for you, we can guide you through retirement by conducting regular reviews of your long-term plan, including managing the underlying investments.
The value of investments and the income derived from them can fall as well as rise. You may not get back what you invest.
If you are unsure about the most appropriate way to withdraw an income from your pension, why not request a copy of our approaching retirement guide which contains useful tips and information for anyone contemplating retirement.
Alternatively, you can arrange a free initial consultation with a Financial Adviser who can help you.