For many of us, the introduction of the phased drawdown pension has been a wonderful thing, bringing greater flexibility and freedom to retirement planning.
Used properly, a drawdown pension gives you greater choice over your date of retirement and how you tailor your income to your age during retirement – all in a tax efficient way.
However, as always in life, freedom comes with possible dangers. There are rules surrounding drawdown pensions and, unless you’re aware of them and operate within them, you could pay come costly penalties.
Let’s take the case of two investors: Bill Hodge and Chris Mann (not real client).
Drawdown without professional advice prior to becoming a Reeves Client:
Bill, who was in his late fifties, had previously taken some tax-free cash out of his pension and still had a sum of money on this drawdown pot. About 18 months after this, he needed £3,000 to pay for his son’s honeymoon and, without taking advice, he took the money from his drawdown pot.
This immediately had two bad consequences.
First, Bill incurred an immediate tax liability on that £3,000, as it came from the taxable part of his pension. Second, and more serious, this withdrawal triggered the money purchase annual allowance rules, so that in future, the amount of tax relief Bill can get on his pension contributions is limited to an annual £4,000 gross.
Unfortunately for Bill, he continued to contribute into his pension after this event, he had assumed that he could pay the money back in without consequence. He made a lump sum contribution of £10,000 gross (£8,000 net). Bill had to pay back the tax relief received which equated to £1,200. He also had to pay this from his own pocket. Bill was 59 and had been hoping to pay £10,000 into his pension for the next six years. This mistake has cost him a further £7,200 in the tax relief he could have earned over those years.
Drawdown with professional advice
Chris Mann, on the other hand, who was in similar circumstances, took advice. As a result, he took part of the money he needed from his ISA and the remaining balance came by withdrawing tax-free cash from his accrual pension. This way, he had no tax liability and did not fall foul of the money purchase annual allowance rules. By the age of 65, he will be £8,400 in tax relief better off than Bill Hodge. This is because he took advice before he acted.
This article is for information only. Pensions and pension legislation can be complex and if mistakes are made these can be irrevocable and costly. We always recommend you take independent financial advice before taking any action.
These articles are for information only. These articles are based on specific clients and their situation may be different from yours. No advice should be conferred from the articles. No action should be taken without independent professional financial advice as any actions on your pension may be irrevocable and have a big impact on your income in retirement.