For anyone that is considering retirement or perhaps would like to use their pension to provide a top up to their income whilst they enter their final years of work, this article will explain how pension drawdown works.
Essentially pension drawdown is a method of taking money out of your pension. This method is only available to money purchase (also know as defined contribution) pensions, the type of pension that you and/or your employer pay into and you end up with a pot of money based on the amount saved and investment returns. Pension drawdown does not apply to final salary (also known as defined benefit) pensions.
The earliest age at which you can take money out of your pension is currently 55 unless you have severe health issues then the age may be lowered.
Retirement is not essential in how pension drawdown works as you don’t need to be retired in order to take money out of your pension. You just need to be 55 or older. Having said this, if you are still working for an employer and paying into the company pension scheme, you will likely lose all future employer contributions if you decide to use pension drawdown from the company pension.
How pension drawdown works in practice
The key thing to remember with pension drawdown is that the longer you use this method of withdrawing money from your pension the longer your pension remains invested.
How pension drawdown works is that it gives control over your pension fund to you! But that also means you need to manage the investment of your pension. The more money you take out of your pension the quicker it could run out.
This is very different to other pension income options such as purchasing an annuity or final salary pensions .
Pension drawdown still allows you to withdraw a pension tax free lump on retirement or whenever you decide to take money out of your pension. Once you have taken your pension tax free lump sum the remaining pension money will be subject to your marginal rate of Income Tax at the point you withdraw the money.
There are 3 main options in how pension drawdown works in practice.
#1 – Taking a regular income
- You can withdraw a set amount each month, quarter or year.
- You can decide whether you take the money as taxable income, your 25% tax free lump sum broken down into bits or a mixture of both (sometimes referred to as UFPLS).
#2 – Taking a one off lump sum
- You can withdraw as much out of your pension as you want with pension drawdown, even the whole lot if you want to.
- But be careful, anything you withdraw above the pension tax free lump sum will be taxed at your marginal rate.
- So you could end up losing nearly half your pension fund if you are a higher or additional rate taxpayer.
#3 – Leave it untouched
- Once you’ve taken whatever money you need from your pension drawdown you can leave the pension alone.
- It will continue to be your pension and will remain invested for you to potentially use another day.
How pension drawdown works for the right person
Understanding your income needs is essential in how pension drawdown works for the right person.
Flexibility
If you are someone who is due to receive a decent State Pension and other pensions such as a final salary pension you may find all your essential spending in retirement is covered.
Using pension drawdown will give you flexibility in how you withdraw the rest of your pension money. If all your essential spending is covered by other guaranteed pension income you may decide to use pension drawdown to take lump sums out every now and then for larger one off spending.
Or top your income up whilst you are in the early stages of retirement and doing more, then reduce the income as you get older and less active.
Investment management
If you are someone that has the time, inclination and skill to manage your own investments then pension drawdown will allow you the option to make your own investment decisions.
Of course this comes with risk. You are in control of making sure your pension fund does not run out too early from excessive withdrawals and/or poor investment performance.
On the flip side, if your investment strategy is successful, your pension fund could grow in value giving you greater income in the future.
Planning for the next generation
On your death whatever is left inside your pension drawdown can be left as a pot of money to whoever you wish.
Money held inside a pension is outside your estate for Inheritance Tax purposes so how pension drawdown works could be very useful for Inheritance Tax planning.
You may decide to use other savings and investments first, leaving your pension until last to avoid or limit Inheritance Tax.
If you feel pension drawdown is the right option for you do check with your pension provider as not all providers will offer the facility. You may need to transfer your pension to an alternative provider.
If you would like more detail on how pension drawdown works and other pension income options we have created a ‘Pension and Retirement Options Guide’ which is available for you to download.
Pension drawdown and the investment management of it can be a complex area so if you would like to meet for an initial chat to find out more we would be happy to offer an appointment at our expense. Please give us a call to arrange.
Risk warning:
Stock market linked investments and any income from them, can fall as well as rise and is not guaranteed. Any figures quoted are for illustrative purposes and should not be taken as a forecast or guarantee. Past performance should not be seen as an indication of future returns and clients may get back less than they have invested.
