Since the pension freedoms (2015) the choice for those nearing retirement is often between flexi pension drawdown and an annuity. In our experience many struggle with a comparison as they find the pension drawdown rules confusing. In this post, we have tried to cover the key points to note.
Drawdown – The Basics
Drawdown allows you to transfer one or more existing pensions into an investment (Drawdown) pension fund. Once you are 55 you can flexibly access your pension fund to fund your retirement by putting a drawdown plan in place. It is important to note that flexi drawdown only applies for those with defined contribution pensions (not final salary pensions) and not all pension providers offer flexi drawdown arrangements. You may read more about the benefits and risks of drawdown here.
Income and Scheduling
When you set up a drawdown arrangement you may take up to 25% of the total transferred pension fund as a tax-free lump sum. You may schedule this tax-free amount in some way perhaps taking 15% initially and 10% at some later date. If you have several defined contribution pension schemes you may move your pension pots gradually into income drawdown. You can take up to 25 percent of each pension pot you may move tax-free.
If you do select the 25% tax-free option the balance of the pension fund is invested in a drawdown pension fund. You may make withdrawals from your fund as you wish, you may even withdraw the full amount, but each withdrawal you make will be taxed at your marginal tax rate (20%, 40% or 45% depending on your income). In drawdown, it is vital to both manage your pension fund and your withdrawal profile to ensure you do not run out of funds in retirement.
Alternatively, at the point of taking your pension, you may decide that you wish to take Uncrystallised Funds Pension Lump Sums (UFPLS) as an alternative to the 25% tax-free lump sum. If you select this option then 25% of each withdrawal you make will be tax-free with the balance taxed at your marginal tax rate. It is important to carefully select between the 25% tax-free lump sum and the UFPLS route as it can have a major impact on how long your pension fund lasts into retirement. It is also important to consider the tax implications of each option as discussed below.
Tax and Allowances
The amount you can invest in a pension and receive full tax relief is based on your earnings for the year and is capped at £40,000, this is known as the annual allowance. However, at the point, first income is taken from a drawdown account this limit currently falls to £10,000. The limit was set at a lower figure of £4,000 per annum until recently. This change is currently on hold but may be reinstated at some point after the 2017 general election.
It is important to note the reduced Annual Allowance only applies when income is taken not when the point the initial tax-free lump sum is released. It is, therefore, possible to take the initial tax-free lump sum and to continue to receive the full £40,000 annual allowance if no income is taken from the drawdown fund.
For some individuals with comparatively large pension pots, the lifetime allowance may also be a concern. As the name suggests the lifetime allowance (currently £1m) is the overall limit a member can accrue in their pensions during their lifetime without incurring an additional tax charge when they start to draw benefits. Successive Governments have a history of changing tax percentages and limits so it is important to keep up with the latest legislation or employ an appropriate adviser.
Death and Inheritance
One of the potential benefits of flexi pension drawdown is the ability to pass any remaining pension fund on your (and your Spouse’s) death to beneficiaries without an inheritance tax charge.
The pension drawdown rules vary according to the pension holder’s age at death. Should they die before age 75 their nominated beneficiary may
- Take the pension fund in full (or in part)
- Take income from the existing pension drawdown arrangement
- Use the drawdown pension fund (in part or full) to purchase an annuity.
Or any combination of the above, all tax-free.
Should the pension holder die after age 75 the options are as stated above but tax is payable on any income received at the beneficiary’s marginal rate. As an example, if the beneficiary pays the standard tax rate of 20% and the pension income takes them into the higher rate tax bracket then some of the income will be taxed at 40% and some will be taxed at 20%.
The above covers the basic pension drawdown rules but it is important to review the rules in detail according to your personal circumstances before making any firm decisions. Should you have any questions or would like to discuss your personal circumstances in more detail then please do not hesitate to get in touch on 0800 043 8341 or email firstname.lastname@example.org. Alternatively, complete the contact box below and we will Email you an answer to your question (free and without obligation)
The purpose of this blog is to provide technical and generic guidance and should not be interpreted as a personal recommendation or advice. All statements concerning the tax treatment of products and their benefits are based on our understanding of current tax law and HMRC practices both of which are subject to change in the future. Levels and bases of reliefs from taxation are also subject to change and are dependent on your individual circumstances.