How can you strike a balance between retiring when you want to, receiving the income you need and not paying more tax than you have to? Peter Watters spoke to McPhersons Financial Solutions to find out more.
What is drawdown?
For those currently aged 55 and over, drawdown is one of the main alternatives to an annuity. If you don’t need all of your pension to provide a secure income immediately, you can use drawdown to keep your pension invested while drawing an income as and when you want to. There is no maximum limit to the income you can withdraw; which you can stop, start or change at any time to meet your needs. You also have the option to buy an annuity at any point in the future if you wish to.
It is the flexibility of drawdown which makes it appealing.
It offers the potential to increase your pension value through investment growth and the chance to protect your income from inflation. Your loved ones can also continue to withdraw the remaining pension after you die, as an income, or alternatively as a lump sum, and tax free in many cases.
The amount you draw down should depend on how your investments perform and how long you would like your pension to last. Drawdown is higher risk than an annuity; there are no guarantees and your income is not secure. If your investments perform poorly, you withdraw income too quickly or you live longer than expected, you could run out of money.
The tax advantage
The main tax advantage of drawdown is when you don’t need to use all of your pension pot to provide an income. There is no requirement to use your entire pension fund in one go or to draw it at its earliest point.
Partial, or phased, drawdown can be used to maximise this tax advantage; which simply means splitting your pension into parts and converting each part to drawdown at different times, as and when you need the income.
Each time you convert a part of your pension to drawdown you can usually take up to 25% of that amount as a tax-free lump sum up front.
For those who don’t need immediate income, it is possible to just withdraw the tax-free cash for the time being and leave the rest invested to provide a taxable income later on.
This is a strategy favoured by many who are already using drawdown. These investors have taken their tax-free cash and are keeping their pension fund invested for future growth.
You may wish to use this tax-free cash to add to other sources of income. This could be particularly useful if you reduce your working hours or perhaps take on part-time work during retirement. The tax-free cash can supplement your earnings, without increasing the tax you pay.
For example, if you earn £11,000 a year, and you move £30,000 of your pension into drawdown, you could take up to £7,500 (25%) as a tax-free lump sum up front; boosting your annual ‘income’ for that tax year to £18,500. Assuming you receive no other taxable income in that same tax year, the whole £18,500 would be tax free. The £22,500 remaining in drawdown could be left invested to draw a taxable income from in later tax years.
You can move more money into drawdown as many times as you like, until you have exhausted the tax-free cash part of your pension. You could repeat this process while you transition into full retirement, replacing any reduction in your earnings with tax free cash or taxable income from your pension.
It’s important to remember tax rules can change and benefits depend on individual circumstances.
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What you do with your pension is an important decision. Therefore, we strongly recommend you understand your options and check your chosen option is suitable for your circumstances: take appropriate advice or guidance if you are at all unsure.The government’s Pension Wise service can help. Pension Wise provides free impartial guidance on your retirement options.