Introduction to withdrawing pensions
Since April 2015 savers have been able to access their pensions with a large amount of flexibility. Given that there are now several possible ways to take pension income, those approaching or in retirement should consider carefully how to draw their pension savings.
This knowledge article briefly explores six possible strategies used for pension withdrawals. Options 1 and 5 will mean you pay more income tax and should only be used in very specific circumstances.
We use an imaginary client, ‘David’, and take him through his pension income choices, exploring some common situations. We have used a pension fund valued at £300,000 to show the calculations below. In each situation, David is assumed to have different needs, which highlight why he might use each of the scenarios. David is aged over 55, so he can access his pensions flexibly.
Any tax you pay on your pension income is only part of the story. There are many other points that need to be covered when taking pension income. Speak to us for a full assessment of your circumstances.
How pensions have changed
There are now lots of ways retirees can take pension income, firstly let’s compare the traditional approach to the modern approach then we’ll break down the modern approach by taking David through a number of scenarios.
Guaranteed pension annuity – the old-fashioned way
This involves handing your pension savings over to an insurance company, who, in return, guarantees to pay you an income every year until you pass away. Some annuities can include spousal pensions and guaranteed periods for a higher cost. Features such as increasing the income in line with RPI or at another growth rate are available, again at a higher cost.
The main upsides to this are guaranteed income, lower costs and certainty and may still be appropriate for some retirees or as part of a retirement plan. The main downsides are lack of flexibility (you can’t normally change the income once it is set up) and that the annuity normally dies with you, so no unused pension savings can be passed to your spouse or children.
Flexible pensions – the modern approach
The new flexibility rules should have pension savers thinking in a whole different way about their pension savings.
Pensions are now more like a savings account or an ISA that you can’t normally access until you are 55. The new rules have made the decision about how to draw your pension more complex as there are various different options. On the plus side, the flexibility and control you now have over your pension savings means that you can enjoy retirement as you want and then leave any unused pension fund to your spouse or children. On the downside, there is investment risk, some costs and the issue that, if not properly managed, you might run out of retirement savings early.
Things to bear in mind
Pension are taxed in different ways at different stages.
– Whilst contributing you get tax relief from the government at your marginal rate. A basic rate tax payer would see an extra 25p added to their pension pot by the government for every £1 paid in, up to a limit.
– As your pension fund is invested and is growing ready for retirement, any growth on the investment is completely tax free. Pensions are very tax-efficient ways of saving for retirement.
– When you access your pension in retirement you get 25% of the fund tax free and the rest of the fund is taxed as income at your marginal rate. In retirement you still have your personal allowance available (£12,500 for 2020/21) and you do not pay National insurance contributions on your pension income.
– When you access the taxable part of your pension, the amount you can continue to pay into your pension is reduced to £4,000 a year (tax year 2020/21). If you contribute more than this you may be subject to a tax charge. This is important if you access your pension but keep working and you auto enrolled in your company pension.
We will now go through six difference situations about how you can use your pension income in retirement under the new flexibility rules.
Please be aware that emergency tax is not considered in this article. Emergency tax can apply initially for the first few withdrawals depending on the level of income required, however a rebate may be due providing the higher or additional rate thresholds have not been exceeded for the tax year.
Scenario 1 – Draw your full pension with tax
When David hits retirement, he just wants to take his money and run. Some people see that their pension savings are inaccessible for many years, and now that they can get their hands on the money they want it in their bank account.
However, this overlooks that pensions are now more like an ISA or bank account that you can access as and when you want during retirement.
If David withdraws his full pension fund, not only will he pay income tax on her withdrawal – at the additional rate for a large portion of the fund, but he will also start paying tax on the remaining funds in her bank account if the account accumulates interest.
Based on pension savings of £300,000 – he can take 25% of her fund as a tax-free pension withdrawal, which is £75,000.
The remaining 75% is taxable against his income. Assuming she has no other income for the tax year, she will pay £86,250 in income tax. The total of her fund paid out is £213,750.
David has paid quite an eye watering amount of tax paid on the pension fund. Plus, all of David’s pension fund is now completely exhausted. The only reason David might choose this option is if he desperately needed a large amount of capital and has no other source of funds.
Scenario 2 – Take full tax free lump sum withdrawal
Taking a tax free lump sum has always been available, even under the old rules when the only option was an annuity. Previously a pension saver would take the tax free lump sum and use the remaining pension fund to purchase an annuity. Under the new flexibility rules, David would take a tax-free pension withdrawal as 25% of the fund. The remaining fund could be left invested in the income stage and would continue to grow tax-free.
Using an example £300,000 pension value, David would withdraw £75,000 tax-free, and leave £225,000 invested tax-free in his pension. Any future withdrawals would be taxable at David’s marginal rate.
David might choose option 2 if he needs access to capital to spend – perhaps to pay off a large mortgage or for a large capital expenditure such as purchasing a holiday home.
David should not withdraw the full tax free lump sum if he doesn’t need all of it. If he does, he will start to pay tax on any unused fund if left in bank accounts and accumulating interest. Additionally, any unused tax free sum if pulled back into David’s estate and might attract Inheritance Tax depending on the value of the rest of his estate.
If David does not need all the 25% tax free lump sum, he would be better to leave it invested to grow tax-free in the pension plan, and to withdraw it later, perhaps in stages when he needs further funds (as Scenario 3 below demonstrates)
Scenario 3 – Partial tax-free lump sum withdrawal
Here, David needs a smaller tax-free lump sum, so he splits his fund into 2 to allow him to access part of the fund. He then leaves the remainder of the tax free sum for future tax-free pension withdrawals.
David wants to withdraw £40,000 to pay off his mortgage balance. He would move £160,000 from the accumulation stage to the income stage (called “Crystallisation”). She can then take 25% of his “crystallised” fund as a tax-free lump sum, paying £40,000 into his bank account.
Once David has taken his £40,000 sum, the remaining £260,000 is left in his pension plan to grow tax-free. £140,000 would still be in the accumulation stage (“uncrystallised”) and could generate further tax-free withdrawals later; £120,000 would be in the income stage (or “crystallised”), and would be subject to income tax if withdrawals are taken from this part.
This is a good option for David if he wants to clear a smaller debt or perhaps book that holiday of a lifetime that he and his wife have been waiting for.
David would only withdraw the amount he needs to spend and leave the rest to grow tax free inside of his pension.
Scenario 4 – Take a tax-free income
In this scenario, David does not need a lump sum but instead requires a regular, modest income from his pension. Here he can use a combination of the tax-free lump sum, and his income tax annual allowance to take up to £16,666 as a tax-free income based on his 2020/21 tax year personal allowance.
This scenario assumes David does not have other taxable income sources – therefore his only source of income is his pension. David would crystallise £16,666 of his pension – £4,166 (25% of £16,666) would be paid as a tax-free lump sum.
David can then take £12,500 as a taxable income to use up all of her personal allowance for the 2020/21 tax year. Adding the tax free sum of £4,166 above gives him a total tax free income for the year of £16,666.
Once David had taken this sum he would have £283,334 remaining uncrystallised and growing tax free.
David’s pension contributions would now be limited to £4,000 per year as he has accessed the taxable element of her pension, which shouldn’t be a problem as long as he is fully retired. All of David’s income has been paid tax free.
David would consider option 4 if he does not need a high level of regular income and wants to take a tax-free income from his pension using available allowances. David might have other savings such as ISAs or instant access savings he can rely on.
Scenario 5 – traditional drawdown of income with tax
Under the old pension rules, David might have been able to take a flexible, taxable income, known as capped drawdown.
Under these rules an option would have been available to take a number of tax-free lump sums and taxable income together. There were limits to the withdrawals he could take – these limits were removed by the new flexibility rules.
In this scenario David needs an income of £2,500 per month after tax, and he has no other sources of income.
Using the traditional drawdown method, we would need to calculate the amount needed to be paid out, taking into account the income tax on the withdrawal. David could crystallise £33,350.
25% of this amount would be a tax-free lump sum, or £8,337.50
The remaining £25,012.50 would be paid out, but subject to income tax. David would pay income tax of £2,502.40. The total he but would receive is £30,000 income after tax due to the tax free amount above.
Once David has received the first year of income his remaining pension has been reduced to £266,650 because of the income tax payable.
David might consider this option if he wants a greater level of income. However, Scenario 6 below, has a more tax-efficient withdrawal method, at least in the early years.
David should also plan ahead carefully and regularly review his pension as his greater level of withdrawals might reduce his pension fund quickly. David should also be aware that by accessing a the taxable element of his pension, his contributions would be capped at £4,000 a year.
Scenario 6 – fully tax-free flexible income (new rules)
The new flexible pension rules allow David to take tax-free pension withdrawals from different parts of his pension plan, at various stages.
Here David still requires £30,000 income, but he can arrange this so that no income tax is paid, at least in the early years of the pension plan. This is particularly useful if David plans to retire before his state pension entitlement and needs to bridge his income for a few years.
The aim is for David to leave the maximum amount to grow tax-free in her pension fund and, as such he might extend the lifetime of her money (depending on investment returns). In this scenario David would crystallise a higher amount of £70,000.
This is then divided into two so that he takes 25% of £70,000 – or £17,500 as a tax-free lump sum, plus £12,500 as a taxable income (we assume that David has the full income tax annual allowance available to him). The total withdrawal would be £30,000 and would be a tax-free pension withdrawal.
David completely avoids income tax on this pension withdrawal, leaving £270,000 in his pension fund to grow tax-free. Of this fund, £230,000 is uncrystallised and £70,000 is crystallised.
Again, as David has accessed the taxable element of his pension he would not be able to contribute more than £4,000 per year into his pension.
I hope that you found these different scenarios for pension withdrawals useful. The flexibility of pensions is clearly a good thing, but it can be complex and those reaching or planning for retirement are encouraged to seek independent financial advice. This guide does not represent financial advice in of itself and should not be construed as such. This guide doesn’t take into consideration any other income sources or what a retiree might want to use their pension for. For free, impartial discussion about your pension savings – please get in touch.
This guide was written by Craig Croft-Rayner, an independent financial adviser at Milestone Financial Planning. It is a for guidance only and is not in of itself financial advice. Should any of the above apply to you, please get in touch for a free consultation.