How is Phased Income Drawdown Taxed?
Phased or gradual income drawdown sees you slowly shift your pension pot into drawdown over time. Every time you withdraw cash from your pension via phased income drawdown you take just some of the 25% pension commencement lump sum you’re entitled to.
Each time you designate a chunk of cash to drawdown, the first 25% is tax-free. The cash you leave behind stays invested with your pension provider.
In the example below, Brenda has a total pension of £100,000. She is entitled to take up to 25% of her pension, so £25,000, tax-free.
But Brenda only needs some of that available tax-free cash today – in the example below she wants £10,000, or 10% of her total fund value.
How Gradual Income Drawdown Works
Remember that whenever you take tax-free cash from your pension, it comes with a non-negotiable taxable element along with it worth three times the tax-free cash. This element is designated to pension drawdown.
In Brenda’s case, her £10,000 tax-free cash would also need to be taken alongside £30,000 for a total designation to drawdown of £40,000.
Of this, Brenda would receive £10,000 as tax-free pension cash, 25% of the total amount (£40,000) drawn down from her whole pension pot. The £30,000 moved to pension drawdown will be added to her total income in the tax year she chooses to take it and, if she exceeds her personal allowance, she’ll be charged income tax on withdrawals from the drawdown fund.
After accessing £40,000 of her pension, Brenda has £60,000 still invested. Of this amount, 25% is available tax-free and the remainder (i.e. £45,000 plus investment growth) will be potentially taxable income when she chooses to take it.
For simplicity, this chart assumes no investment changes to Brenda’s pension. This is very unlikely given that a sizeable proportion of her fund will remain invested, so it’s important to consider that the value of Brenda’s retirement savings could go down as well up in line with markets.
Can I Take Small Tax-Free Lump Sums from My Pension?
Yes — you can take small tax-free lump sums from your pension with gradual income drawdown, assuming your pension arrangement permits it.
For each tax-free lump sum you take you must also allocate a non-negotiable amount to drawdown worth three times the amount you get tax-free. So if you wanted to withdraw £5,000 of tax-free cash, you’d also have to allocate £15,000 of taxable cash to your drawdown fund. Remember, that £15,000 will potentially be taxable as income when you need to take it.
In this example, £20,000 has been designated from your pension to drawdown, of which £15,000 remains invested.
Should I Move My Pension to Drawdown Gradually?
Those with the largest pension funds will typically benefit the most from gradually moving their pension pot to drawdown. This is because the tax-free cash element, when withdrawn, will form part of your estate for inheritance tax purposes.
If you have a £1 million pension pot and opt to withdraw your entire pension using income drawdown, the 25% tax-free cash element would be worth £250,000 and become part of your estate. When added to your other assets, such as your home, it’s clear to see that this could easily breach the inheritance tax nil-rate band threshold of £325,000 per individual.
Pension Drawdown and the Lifetime Allowance
Moreover, those with large pension pots might have a pension lifetime allowance issue. The lifetime allowance is currently £1 million, which is the amount you can withdraw from your pension in your lifetime before paying the lifetime allowance charge. This charge could be a hefty 55% on everything you take above your lifetime allowance.
When you move cash to drawdown, you crystallise part of your pension pot (known as a benefit crystallisation event). So if you move your whole pension to drawdown at once you crystallise the entire pot. Those with a large pension could then be hit with the lifetime allowance charge as soon as they access their pension.