How does pension drawdown work?

How does pension drawdown work?
  • Retirement Planning
  • 4 minute read

Pension drawdown is a popular way of generating an income from your pension in retirement. When you put your pension into drawdown, you keep the majority of your pension savings invested, while making flexible withdrawals from your pension pot for income. In this article, we look at how pension drawdown works and highlight the advantages and disadvantages of this pension decumulation strategy.

What is pension drawdown?

Pension drawdown, or ‘flexi-access’ drawdown as it is sometimes called, is a way of taking your money out of your pension to generate income in retirement. With pension drawdown, you’re able to keep the bulk of your pension savings invested when you reach retirement age, while withdrawing an income from your pension to fund your retirement.

How does pension drawdown work?

You can move your pension pot into drawdown from the age of 55.

Once in drawdown, you can take up to 25% of your pension pot as a tax-free lump sum. You can then make withdrawals from the remainder of your pension balance that can be used for retirement income. There are no limits in terms of how much you can withdraw at once from your remaining pension savings. You also have flexibility over the amounts you withdraw and the timing of the withdrawals.

With pension drawdown, you are not locked in for life. At any time, you can use your pension savings to buy an alternative retirement income product.

What are the advantages of pension drawdown?

Pension drawdown offers a number of benefits.

One of the main benefits is the high level of flexibility you have. You can take income when it suits you and adjust the amounts you withdraw depending on your income requirements or the performance of your pension investments. You can set up regular monthly or annual income payments, or take ad hoc payments when you need to. And unlike an annuity, you are not locked in to a plan for your entire retirement.

Another benefit of pension drawdown is that you can keep the majority of your pension savings invested while in retirement. This means that you can continue to grow your pension savings after you have retired.

The fact that you can take 25% of your pension savings as a tax-free lump sum is also a benefit.

What are the disadvantages of pension drawdown?

One major disadvantage of pension drawdown is that your income is not guaranteed. This means that you need to plan your income withdrawals carefully. You need to ensure that you have enough income to last your entire retirement. If your pension investments decline in value, or the income they produce doesn't keep up with inflation, you may have to lower your withdrawals so that you don't run out of money later on in retirement.

With a pension drawdown, you also need to spend time choosing and monitoring your pension investments. You’ll need to choose a mix of investments that is suitable for your financial requirements and risk tolerance. You’ll then need to regularly monitor your investments in order to ensure that they are producing sufficient capital growth and income. 

How do you set up a pension drawdown?

To set up a pension drawdown, you need to ask your pension provider to move your pension into drawdown. Normally, you have to complete a pension drawdown application form. Not all pension schemes offer drawdown plans to their members though. If your pension provider does not offer drawdown, one option is to transfer your pension pot into a Self-Invested Personal Pension (SIPP) and then switch on the drawdown facility.

It’s worth pointing out that different pension providers have different fee structures for pension drawdown. It’s important to fully understand the fees and charges you’re facing to make withdrawals from your pension.

How do you work out how much income to drawdown?

Determining how much income you can afford to take under pension drawdown requires careful planning. The amount you can withdraw will depend on a range of factors including:

  • The size of your pension pot
  • Other sources of income in retirement
  • The performance of your pension investments over time
  • Inflation rates
  • How long you expect to live
  • Whether you want to provide for someone else after you die

Pension drawdown calculators can be useful when determining how much income to withdraw in drawdown. However, these calculators have their limitations as they are based on assumptions. As such, it can be a good idea to consult a financial adviser. An adviser will be able to provide you with more personalised pension drawdown advice.

How does pension drawdown tax work?

With pension drawdown, you can take the first 25% of your pension pot tax-free. Any subsequent withdrawals are then subject to income tax.

Income tax bands for 2020/2021 are shown below.

Band Taxable income Tax rate
Personal Allowance Up to £12,570 0%
Basic rate £12,571 to £50,270 20%
Higher rate £50,271 to £150,000 40%
Additional rate over £150,000 45%

* Note that income tax bands are different in Scotland.

So, for example, if you have pension savings of £1 million, you could potentially take £250,000 tax-free. If you then withdrew £50,000 from your pension for income and had no other income during the year, you would have an income tax liability of £7,486 after taking your personal allowance into account.

If your pension savings exceed the Lifetime Allowance (LTA), you may face extra tax charges on your pension withdrawals. You can find out more about the Lifetime Allowance in this article here.

What happens to your pension drawdown if you die?

You can normally pass on pension savings free from Inheritance Tax (IHT). However, the beneficiary of your pension may have to pay tax depending on how old you are when you die and the timing of the transfer.

If you die before the age of 75, any remaining pension drawdown passed to your nominated beneficiary within two years is tax-free. If the money is claimed more than two years after your death, however, it will be added to the beneficiary’s income and taxed at their appropriate income tax rate.

If you die aged 75 or over, any pension savings paid to your beneficiary will be added to their income for the year and taxed at their appropriate income tax rate.

It’s important to complete an ‘expression of wish’ form so that your pension provider knows exactly who your pension beneficiaries are.

What are the alternatives to pension drawdown?

There are a few alternatives to pension drawdown.

One alternative is an annuity. Here, you use your pension savings to buy a guaranteed income stream for the rest of your life. The advantage of annuities is that they provide you with more security. On the downside, however, they are far less flexible than pension drawdown.

Another option is to take ad-hoc withdrawals from your pension pot. These withdrawals are known as uncrystallised funds pension lump sums (UFPLS). With this strategy, you can take all your pension in one go, or take a series of smaller lump sums as and when you need to. This approach has similarities to pension drawdown but the tax treatment is slightly different. As above, with pension drawdown, you can take a 25% lump sum tax-free and then all other payments are subject to income tax, with UFPLS, the first 25% of every withdrawal is tax-free, with the remaining 75% of that payment subject to income tax.

If you are unsure about the best approach for your requirements, it’s a good idea to speak to a financial adviser.

Pension drawdown: a flexible retirement income strategy

In conclusion, pension drawdown is a decumulation strategy that offers many benefits. Not only does it provide you with a high level of flexibility in terms of your retirement income, but it also enables you to continue growing your savings throughout retirement. Though you must remember, the value of investments will go up and down and you could end up with less than if you were to take an annuity.  An individual’s circumstances will also affect any tax benefits of different income solutions.

It's also important to understand that pension drawdown is not something that you can set up once and forget about. This retirement income strategy needs to be carefully managed, ideally with the help of a qualified financial adviser. An adviser will be able to monitor your pension investments, help you determine the optimal level of income to withdraw from your pension, and provide advice if your circumstances change.

To find out more, or if you have any questions about pension drawdown, don’t hesitate to request a call back by clicking the button below.

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