What is Pension Drawdown?
Pension drawdown is an alternative way of taking (or drawing down) your pension than an annuity. It allows you to keep your pension pot invested throughout retirement and benefit from any future growth in the markets.
Following the April 2015 pension freedoms, drawdown became officially known as flexi-access drawdown because it offers a more flexible way to access your pension.
You decide how to take your pension, whether this is in a series of lump sums, income payments or a mixture of the two.
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Rules of Pension Drawdown
Can I Use Income Drawdown?
The two main rules surrounding whether or not you can use pension drawdown are having a defined contribution or money purchase pension and being aged at least 55.
You can’t access your pension before the age of 55 unless you’re very ill or are a member of a scheme that permits early retirement.
Don’t be tempted by companies offering to ‘unlock’, ‘release’, ‘free’ or otherwise access your pension before the age of 55. Unless you’re absolutely certain you meet the criteria for ill health or early retirement it’s simply not possible. Such companies are likely a front for fraudsters trying to get their hands on your hard-earned pension savings.
If you’re unsure, speak to an professional pension adviser on the Financial Conduct Authority’s register, such as Drewberry, who can offer help and advice in this area.
Senior Paraplanner at Drewberry
Those with a final salary or defined benefit pension also can’t access their pension via drawdown. A defined benefit pension pays a regular income and the rules surrounding how you can take that income are very different.
If you want to use drawdown and you’re in a final salary scheme, you might want to consider a defined benefit pension transfer. However, a final salary transfer isn’t right for everyone and you need to give it careful consideration, ideally by consulting an expert pension transfer adviser.
Other pensions that won’t typically allow income drawdown include:
- Section 226 retirement annuity contracts (RAC) or section 32 buy-out plans
- Defined contribution occupational schemes
- Additional voluntary contribution (AVC) and free-standing AVC plans
- Many older personal pension contracts, including stakeholder or group personal pension (GPP) arrangements.
How Do I Access My Pension with Drawdown?
There are three main ways to take cash from a drawdown pension. These are:
- Withdraw your 25% tax-free cash and move the rest to drawdown – the 25% is tax-free while the 75% allocated to drawdown will be taxable as income when you take it.
- Take just some of your tax-free cash lump sum – if you don’t need your entire tax-free cash allowance, you can take just a proportion of it providing you move a sum equivalent to three times the amount you withdraw to drawdown. This preserves the mandatory 25% tax-free/75% taxable split for pension drawdown withdrawals. It’s known as phased or gradual income drawdown. The remainder of your pension remains uncrystallised and invested, giving you the option to take further lump sums in the future on the same terms.
- Take an uncrystallised funds pension lump sum – this doesn’t involve allocating cash to pension drawdown. Instead you simply withdraw cash lump sums (25% of which are tax-free and 75% are taxable) direct from your pension pot.
How Often Can You Take Money Out of Drawdown?
This depends entirely on your pension provider’s rules, but typically you can withdraw income and/or lump sums as you want, when you want.
There may be a charge for each withdrawal you make from your drawdown pot, so it’s important to check this first. It should be one of the major considerations when comparing the different income drawdown providers.
How Is Pension Drawdown Taxed?
Tax When Moving Your Whole Pension to Drawdown
The way pension drawdown is taxed in retirement depends entirely on how you opt to take your pension.
If you choose to designate your entire pension pot to drawdown, the first 25% will be available as tax-free cash. Of the remaining 75%, the money will be taxed as income in the year you choose to take it.
Once you’ve allocated 75% of your pension pot to flexi-access drawdown, you can invest it to provide a taxable income stream, take taxable lump sums or a mixture of the two.
The rules of income drawdown mean that you can’t just take 25% tax-free cash from your pension and leave the rest. If you do so, you need to move the remaining 75% to a pension drawdown arrangement.
However, once that 75% is in a compatible drawdown arrangement, you don’t have to touch it straight away. It’s fine to leave it invested and take a potentially taxable income from it as required.
Pensions & Investments Expert at Drewberry
Tax on Phased Pension Drawdown
Phased or gradual income drawdown sees you take only a proportion of your tax-free cash. When you do so, the rules of drawdown mean you must move the equivalent of three times your tax-free amount to a drawdown arrangement.
Each time you allocate a chunk of your pension to drawdown, the first 25% is tax-free. The remaining cash in your pension stays invested with your pension provider.
Example: A £100,000 pension pot
In the example below, there’s a £100,000 pension pot. The pensioner is entitled to take £25,000 (25% of the total) as tax-free cash, but they only want to take £10,000.
When you take tax-free cash from your pension, it comes with a mandatory taxable element worth three times the tax-free cash that must be moved to drawdown.
So for a £10,000 tax-free withdrawal, you’d have to move £30,000 to drawdown for a total withdrawal of £40,000. The £30,000 moved to a drawdown arrangement is taxable as income in the year they choose to take it.
After accessing £40,000 from their pension pot, the pensioner above still has £60,000 invested with their pension provider. Of this £60,000, 25% is available tax-free and the remainder will be potentially taxable as income in the year they choose to take it.
Note that, for simplicity’s sake, the above example assumes no investment growth at all in either the drawdown element or the amount that remains invested with the pension provider. This is very unlikely given that a sizeable proportion remains invested, so the figures involved could go down as well as up in line with markets.
Tax on Uncrystallised Funds Pension Lump Sums
Uncrystallised funds pension lump sums (UFPLS) are also known as FLUMPs. They offer a very similar way of taking your pension compared to drawdown. However, there’s no drawdown fund involved – instead, you withdraw cash straight from your pension pot.
25% of any amount you withdraw from your pension is tax-free and 75% is taxable as income in the year you choose to take it. The remainder of your pension pot stays invested, untouched and uncrystallised.
What Happens To My Drawdown Pension When I Die?
How your drawdown pension is treated when you die depends on how old you are when you pass away.
The 55% ‘death tax’ on pensions has been abolished with pension freedoms. However, there may still be some tax to pay on a drawdown pension if you die after the age of 75.
If, however, you die before the age of 75 your beneficiaries won’t usually have to pay any tax at all on your inherited pension, regardless of how they take the money. Beneficiaries can take the money as one lump sum, continue with drawdown income or buy an annuity – all totally tax-free. They also don’t have to be 55 before accessing the pension; they can do so at any time.
Inherited flexi-access drawdown pension pots are only paid tax-free if the recipient receives them within two years of the original pensioner passing away.
If you die after the age of 75, there will be tax to pay on the inherited pension. While your beneficiaries still have the ability to take the inherited pension as they see fit, each option will be taxed as income at their highest marginal rate.
Regardless of when you die, there’s no inheritance tax to pay on a drawdown pension pot. This is because the pension falls outside of the estate for inheritance tax purposes because, technically, it’s a ‘discretionary’ payment by the provider on your death.
Wealth & Investments Expert at Drewberry
Do I Have to Use My Current Pension Provider for Drawdown?
No, and in fact you’re probably better off shopping around to find the best drawdown pension for you.
It’s important to compare drawdown providers thoroughly before making any decisions. This is because while the product on offer may feel like same – namely a flexible way to access your pension – each provider will have a different proposition.
Things to looking out for when doing income drawdown comparison include:
- Access to funds – given the whole point of pension drawdown is that you remain invested during retirement, you want access to the widest range of funds/investments possible.
- Ease with which you can vary your income – flexi-access drawdown is supposed to be flexible, but not every provider will offer the maximum level of flexibility you require. How easy will it be to vary your income?
- Fees and charges – how much drawdown costs should be a key consideration. You should look at everything from set-up/administration charges to fees for withdrawing income.
- Online access – many people want to manage their money online and on the go. if this is important to you, does your chosen provider have a good digital proposition?
While it’s possible to compare drawdown pension providers yourself, it’s not an easy task. There’s so much to think about and it can be complicated, so why not ask a pension expert to do the hard work for you?
What If I Was Already In Drawdown Before April 2015?
If you were in drawdown before April 2015, you were in one of two arrangements: capped drawdown or flexible drawdown.
Flexible drawdown was most similar to today’s flexi-access drawdown arrangements. Capped drawdown, however, limited the amount you could withdraw from your pension. The cap was what you’d receive from an annuity, based on the Government Actuary Department’s statistics.
Flexible drawdown pre-April 2015
If you were in flexible drawdown before April 2015, then your pension will automatically have been converted to flexi-access drawdown. You have all the same freedoms as someone who took out a new flexi-access drawdown contract post-April 2015.
Capped drawdown pre-April 2015
If you were in capped drawdown before April 2015 then you have a decision to make. Either you can choose to continue in capped drawdown, with all the limitations this entails, or move to a new flexi-access drawdown arrangement.
Moving from capped drawdown to flexi-access drawdown could be an active decision. However, it could also be triggered as soon as you breach the old cap you were subject to.
Although there’s a limit on how much you can receive each year from a capped pension drawdown contract, the money purchase annual allowance doesn’t apply to you (see below). This means you can continue paying in your full annual allowance each year into the pension.
Once you’ve made the decision, there’s no undoing it so think carefully.
Can I Still Contribute to a Pension in Drawdown?
Yes, but anyone in a new drawdown contract (i.e. flexi-access drawdown) will have a strict limit on how much they can take from their pension once they’ve accessed more than their tax-free cash lump sum.
After being put on hold following the snap election in June 2017, legislation was introduced that brought in a tighter cap on how much you can contribute to a pension after retiring. This new cap stands at £4,000 and was backdated to the start of the 2017/18 tax year.
This means that most people who’ve accessed their pension flexibly can now only save £4,000 a year into their pension, a tenth of the ‘normal’ annual allowance of £40,000 per year.
Can I Still Buy an Annuity?
Yes, you can still buy an annuity. There’s no requirement for you to use drawdown if you don’t want to.
The benefit of drawdown is that it’s flexible. That means you can opt to use income drawdown in the early years of your retirement, when you have need for a more flexible income or access to larger lump sums, perhaps. Then, in your later years when you want to take less investment risk or are keen for a steady, guaranteed income you can opt to buy an annuity with the remainder of your pension pot.
If you use your entire pension pot to buy an annuity from the outset at retirement then there’s no going back and making the decision to use drawdown instead. Annuities are irreversible once purchased so you can’t change your mind.
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Do I Need Income Drawdown Advice?
No, you don’t necessarily need pension drawdown advice, unless you’re moving from a final salary scheme worth more than £30,000 to a money purchase scheme to make use of drawdown.
However, while the regulations and rules of pension drawdown don’t typically demand you take professional advice, the guidance offered by a financial adviser can be valuable in so many areas.
From finding you the best drawdown provider for your needs to managing your investments based on your risk appetite and income requirements, an adviser can help make drawdown simple.
An adviser can also help manage your pension fund to reduce the risk of it running out too early thanks to excessive withdrawals. The team at Drewberry is here to help and is available on 02084327333.
Director at Drewberry