What is pension drawdown?

what is pension drawdownYou spent your working life investing in your pension and have finally retired. Now it’s time to start taking an income from your pension pot, either by purchasing an annuity or by moving your fund into drawdown and taking money out as cash.  But what exactly does that mean? What is pension drawdown?

In the past, most people had only one option in terms of generating an income from their personal pension. They were forced by law to buy an annuity. A few wealthier savers, with much larger pots, were afforded the right to draw an income from their investments directly. But the way in which they could then do so was also tightly controlled.

The introduction of new pension freedoms in 2015 changed all that. For the first time savers were put in control of how and when they created an income from their retirement fund.

What is pension drawdown?

You can now choose whether to trade in your pension for a guaranteed income for life via an annuity or to keep your pension fund invested and create an income by taking cash from the fund as a single lump sum or as regular or occasional withdrawals.

Flex-Access Drawdown as it is called can be taken from age 55, or earlier if you’re prevented from working by ill-health or are working in a protected occupation.

To start drawing down from your pension you first need to crystallise all or part of your fund at which point it gets valued by HMRC to check that it is within your lifetime allowance. This done, you can draw down on your funds whenever you want.

Can a defined benefit scheme member use drawdown?

Yes. People with defined benefit (final salary or CARE) pensions are no longer tied to taking their scheme benefits. By transferring your scheme benefits out into a private pension, members can use flexi-access drawdown to create an income.

Reasons to choose drawdown

There are three reasons why you might consider pension drawdown over buying an annuity or sticking with your final salary scheme benefits

  • Flexibility. There are no rules that determine when and how you draw down your income. Say, for example, you and your spouse want to retire today. Your spouse will receive a substantial income from their defined benefit pension in two year’s time. There’s nothing to stop you drawing down your entire pension to cover your living expenses in the meantime.
  • Control. You get to make the decision about how your pension fund is invested and, through doing so, influence the returns and income you receive from your pension.
  • Inheritance Tax. Subject to certain conditions, any money that remains in your pension fund can be passed onto your beneficiaries free of inheritance tax.
  • Death Benefit.  Income from a defined benefit scheme is lost on the death of you and your spouse, if you have one. Transferring out of a defined benefit scheme into a drawdown arrangement means that your beneficiaries can benefit from any unused funds when you die.

What about tax?

Pensions currently operate on an Exempt-Exempt-Taxed (EET) basis. This means that you do not pay income tax on contributions paid into your pension fund, the fund grows free from capital gains tax and money you take out of your pension is taxable at your marginal rate.

However, when you stop paying into your pension and crystallise the fund, you can draw down a lump sum of up to 25% of the crystallised fund value tax-free.

This lump sum is very useful if you need to pay off a small balance on your mortgage, take a special holiday or help your children to buy their first property.

But what if you don’t need to take a big chunk of pension in one go? By crystallising only part of your fund each year and taking the income you need as your tax-free lump sum, you can keep your money invested in your pension. This means that your investments can continue growing tax-efficiently.

Considerations

Working out how and when to draw down money from your pension is complex. Get it wrong and you could lose a lot of money. If you’re thinking about pension drawdown you should be aware that:

  • Your income will not be guaranteed. If markets fall shortly after you crystallise your pension, the detrimental effect of any money you withdraw from your fund will be amplified and may harm your future income for life.
  • You could run out of money altogether. If you withdraw too much money, too quickly you may find that you run out of money earlier than you had planned.
  • You can’t “fit and forget” your retirement income. Your pension fund will require management up to the point you die. You’ll need to think about appointing a Power of Attorney if you don’t feel comfortable with the idea of making decisions when you’re in your ’80s.

Getting professional advice is therefore paramount.

 Does this help you answer the question of what is pension drawdown? Is there anything else you’d like me to cover in greater detail? Comment below if you have any questions.

Pensions are a long term commitment, you may not be able to access you pension funds until the age of 55 (currently), investments can go down as well as up and you might not get back your initial capital. Pension and tax legislation does and can change in the future which could impact your pension.

 ultimate retirement planning guide

Spread the Word
Related Posts
No related posts for this content

About the Author

By Nigel Reeves: My mission is to provide the quality, honest & jargon-free pension advice that people need to secure the retirement they deserve. At home, I'm a family man and an active supporter of grassroots sports!

Leave a Reply 0 comments