Unlocking Your Pension – Understanding the Basics of Pension Drawdown

Pensions are tax-efficient and extremely flexible. You can use your pension to buy a guaranteed income for life, or you can treat it like any other investment and draw amounts when you need them.

In this guide, we explain how pension drawdown works, as well as some of the factors you need to consider when approaching retirement.

What Happens When You Retire?
Traditionally, it was expected that you would finish work at 60 or 65 and immediately start taking a regular income from your pension. The State Pension would come into payment at around the same time.

But the retirement timeline has changed for most people. Many people are working longer due to rising life expectancy and the cost of living. Others are transitioning gradually into retirement by dropping a few days at a time. Many are opting for a career change later in life, perhaps choosing a lower paid (and lower stress) job or monetising a hobby.

This means that the traditional model of retirement is no longer the norm. Pensions have needed to adapt to this requirement for flexibility.

You can take money out of your pension at any point from age 55, although this is rising to 57 (and will ultimately remain ten years below State Pension age).

How does Drawdown Work?
When you decide to take benefits from your pension, you can ‘crystallise’ all or some of your pot. 25% of the crystallised amount is available as a tax-free lump sum, and the remainder is set aside to provide you with an income.

Any money that you don’t withdraw can be invested in funds, shares, or any other type of investment allowed by your pension scheme.

If you have a pension that was crystallised before 2015, it may be designated as ‘capped drawdown’ rather than ‘flexi-access.’ This means that there are limits on the amount you can withdraw each year. However, it’s a fairly simple matter to move from capped to flexi if you want to withdraw more.

What About Tax?
When your pension fund is invested, all income and growth is free of tax. This means that pensions can grow more quickly than other taxable investments.

25% of your pot is available free of tax. You can take this in one lump sum or use it to supplement your income over a number of years. If you have an occupational pension from before 2006, you might even have a higher lump sum.

The remaining pot is subject to tax at your marginal rate, but only at the point you withdraw it. For example, you could decide to take a pension income only up to the level of the personal allowance or basic rate band to control the amount of tax paid.

When you take taxable benefits (or moved your pot from capped to flexi-access drawdown), this triggers the Money Purchase Annual Allowance (MPAA). This caps future pension contributions at £10,000 per year, with no carry forward option. Taking taxable income from your pension while you are still working needs careful consideration, as it can limit your potential to build up your pot further.  

When you take benefits, reach age 75, or if you die beforehand, your pension is tested against the Lifetime Allowance. This is currently £1,073,100. Pension benefits above this level are taxed at 55% if taken as a lump sum, or 25% (plus income tax) if taken as income. A second test may be applied at age 75 if you have previously moved funds into drawdown. However, as it has been announced that the Lifetime Allowance will now be scrapped from April 2023, this only applies if benefits are crystallised in the current tax year.

What Happens if You Die?
Your drawdown pension can be passed to your beneficiaries when you die. You can provide the pension trustees with an expression of wish to let them know how you would like the fund to be distributed. They are not legally bound by this (otherwise the tax treatment would change), but will normally follow your requests.

Before age 75, any pension death benefits are paid out tax-free. After age 75, your beneficiaries can draw an income which is taxable at their marginal rate. Pensions can be passed through successive generations in this way.

What Are the Other Options?
If drawdown is not for you, the other options include:

• Buying an annuity – this offers a guaranteed income for life, but very little flexibility if your circumstances change or if you want to include death benefits.
• Uncrystallised pension funds lump sum (UPFLS) – this allows you to take ‘slices’ of your pension, with each slice comprising 25% tax-free cash and 75% taxable income.
• Withdrawing the whole fund – this can be suitable if you have a small pot, but can incur significant amounts of tax.
• Leaving it untouched – if you don’t need to take benefits from your pension, it may be tax-efficient to leave it invested and use other sources of income and capital to fund your lifestyle.

Pros and Cons of Drawdown
The main advantages of drawdown are:

• Flexibility over your income, as you can start, stop, or change your income as required.
• The ability to leave your full pot to your loved ones.
• The fund can continue to benefit from investment growth.

The key risks include:

• The fund value will fluctuate with the market and you may lose money.
• You will continue to pay investment costs.
• Drawdown requires regular reviews, and generally includes more admin and paperwork than simply buying an annuity.

Drawdown Tips
Our top tips for a successful drawdown strategy are:

• Make sure you have enough in cash to cover a few years’ worth of income. This means that if the market is volatile, your invested funds will have time to recover before you sell them.
• Invest in a diverse range of assets which are suitable for the level of risk you wish to take.
• Review your withdrawals regularly so that you don’t run out of money.
• Consider your pension as one part of your retirement plan – cash, ISAs, bonds, property, and company shares can all be used to fund your lifestyle.
• Consider working with a financial adviser who can advise you on investment options, taxation, and a suitable withdrawal strategy.

Please don’t hesitate to contact a member of the team to find out more about retirement planning.