More choice and flexibility than ever before
Following changes introduced in April 2015, you now have more choice and flexibility than ever before over how and when you can take money from your pension pot, but it’s essential to obtain professional advice to decide what the best course of action you should take, as this will be your retirement income for the rest of your life.
Changes introduced from April 2015 give you freedom over how you can use your pension pot(s) if you’re 55 or over and have a pension based on how much has been paid into your pot (a defined contribution scheme).
There’s a lot to consider when working out which option or combination will provide you and any dependants with a reliable and tax-efficient income throughout your retirement. Under the new flexible rules, you can mix any of the options below, using different parts of one pension pot or using separate or combined pots.
Leave your pension pot untouched
You may be able to delay taking your pension until a later date. Your pot then continues to grow tax-free, potentially providing more income once you access it. If you already have enough income to live on – either because you are carrying on working or you have other income from savings or investments to live on – you may be able to delay accessing your pension pot beyond your selected retirement date or your scheme’s normal retirement date.
Your pot continues to grow tax-free until you need it – potentially providing more income once you start taking money out. If you want to build up your pension pot further, you can continue to get tax relief on pension savings of up to £40,000 each year (tax year 2016/17) until age 75. Be sure to check with your pension scheme or provider whether there are any restrictions or charges for changing your retirement date, and the process and deadline for telling them. Also check that you won’t lose any income guarantees – for example, a guaranteed annuity rate (GAR) – by delaying your retirement date.
The value of pension pots can rise or fall. Remember to review where your pot is invested as you get closer to the time you want to retire and arrange to move it to less risky funds if necessary.
The longer you delay, the higher your potential retirement income; however, this could affect your future tax – and your entitlement to benefits as you grow older, for example, long-term care costs.
You could instead delay taking some of your pension. For example, you may be able to arrange to retire gradually, or change to working part-time or flexibly and then draw part of your pension. If you want your pot to remain invested after the age of 75, you will need to check with your pension scheme or provider that they will allow this. If not, you may need to transfer to another scheme or provider who will.
Buying a guaranteed income for life – an annuity
You can choose to take up to a quarter (25%) of your pot as a one-off tax-free lump sum, and then convert the rest into a taxable income for life called an annuity. There are different lifetime annuity options and features to choose from that affect how much income you would get. You can also choose to provide an income for life for a dependant or other beneficiary after you die.
A lifetime annuity is a type of retirement income product that you buy with some or all of your pension pot. It guarantees a regular retirement income for life. Lifetime annuity options and features vary – what is suitable for you will depend on your personal circumstances, your life expectancy and your attitude to risk.
You choose to take up to 25% of your pension pot – or of the amount you are allocating to buy an annuity – as a tax-free lump sum. You then use the rest to buy an annuity, which will provide you with a regular income for life.
This retirement income is taxed as normal income. As a rule of thumb, the older you are when you take out an annuity, the higher the income (annuity rate) you’ll get.
There are two types of lifetime annuity to choose from:
Basic lifetime annuities – where you set your income in advance
Investment-linked annuities – where your income rises and falls in line with investment performance, but will never fall below a guaranteed minimum
Flexible retirement income – flexi-access drawdown
With this option, you take up to 25% of your pension pot or of the amount you allocate for drawdown as a tax-free lump sum, then re-invest the rest into funds designed to provide you with a regular taxable income. You set the income you want, though this may be adjusted periodically depending on the performance of your investments. Unlike with a lifetime annuity, your income isn’t guaranteed for life – so you need to manage your investments carefully.
With flexi-access drawdown, when you come to take your pension, you reinvest your pot into funds designed to provide you with a regular retirement income. This income may vary depending on the fund’s performance, and it isn’t guaranteed for life.
You choose funds to invest in that match your income objectives and attitude to risk and set the income you want. The income you receive may be adjusted periodically depending on the performance of your investments. Once you’ve taken your tax-free lump sum, you can start taking the income right away or wait until a later date.
You can also move your pension pot gradually into income drawdown. You can take up to a quarter of each amount you move from your pot tax-free and place the rest into income drawdown. To help provide more certainty, you can at any time use all or part of the funds in your income drawdown to buy an annuity or other type of retirement income product that may offer guarantees about growth and/or income. What’s available in the market will vary at any given time so you should obtain professional advice to discuss your options.
You need to carefully plan how much income you can afford to take under flexi-access drawdown, otherwise there’s a risk you’ll run out of money. This could happen if:
You take out too much in the early years
Your investments don’t perform as well as you expect and you don’t adjust the amount you take accordingly
You live longer than you’ve planned for
If you choose flexi-access drawdown, it’s important to regularly review your investments. Unless you’re an experienced investor, you may well need professional advice with this.
Any money you take from your pension pot using income drawdown will be added to your income for the year and taxed in the normal way. Large withdrawals could push you into a higher tax band, so bear this in mind when deciding how much to take and when. If the value of all of your pension savings is above £1m when you access your pot (2016/17 tax year), further tax charges may apply.
If the value of your pension pot is £10,000 or more, once you start to take income the amount of defined contribution pension savings which you can get tax relief on each year falls from £40,000 (the ‘annual allowance’) to £10,000 (called the ‘Money Purchase Annual Allowance’ or MPAA). If you want to carry on building up your pension pot, this may influence when you start taking income.
You can nominate who you’d like to get any money left in your drawdown fund when you die. If you die before the age of 75, any money left in your drawdown fund passes tax-free to your nominated beneficiary whether they take it as a lump sum or as income. These payments must begin within two years, or the beneficiary will have to pay Income Tax on them.
If you die after the age of 75 and your nominated beneficiary takes the money as income or lump sum, they will pay tax at their marginal rate. This means that any income or lump sum taken on or after this date will be added to their income and taxed in the normal way.
Flexi-access drawdown is just one of several options you have for using your pension pot to provide a retirement income.
Withdrawing small cash sums
You can use your existing pension pot to withdraw cash as and when you need it and leave the rest untouched where it can continue to grow tax-free. For each cash withdrawal, the first 25% is tax-free and the rest counts as taxable income. There may be charges each time you make a cash withdrawal and/or limits on how many withdrawals you can make each year.
With this option, your pension pot isn’t re-invested into new funds specifically chosen to pay you a regular income, and it won’t provide for a dependant after you die. There are also more tax implications to consider than with the previous two options.
However, you need to consider that your pension pot reduces with each cash withdrawal. The earlier you start taking money out of your pot, the greater the risk your money could run out. What’s remaining in your pension pot might not grow enough to give you the income you need to last you into old age – most people underestimate how long their retirement will be.
The administration charges for each withdrawal could eat into your remaining pot, and the funds where your existing pot is invested could fall in value and you could run out of money. Because your pot hasn’t been reinvested to produce an income, its investments could fall in value – so you’ll need to have it reviewed regularly. Charges will apply, and you may need to move or reinvest your pot at a later date.
Once you take money out of your pension pot, any growth in its value is taxable, whereas it will grow tax-free inside the pot – once you take it out, you can’t put it back. Taking cash lump sums could also reduce your entitlement to benefits now or as you grow older.
If the value of your pension pot is £10,000 or more, once you start to take income the amount of defined contribution pension savings on which you can get tax relief each year is reduced from £40,000 (the annual allowance) to £10,000 (the Money Purchase Annual Allowance or MPAA). If you want to carry on building up your pension pot, this option may not be suitable. In addition, if the value of all of your pension savings is above £1m when you die, further tax charges may apply.
Withdrawing your entire pot as cash
You could close your pension pot and withdraw the entire amount as cash in one go if you wish. The first 25% will be tax-free and the rest will be taxed at your highest tax rate – by adding it to the rest of your income.
There are many risks associated with cashing in your whole pot. For example, it’s highly likely that you could become subject to a significant tax bill; it won’t pay you or any dependant a regular income, and without very careful planning you could run out of money and have nothing to live on in retirement.
Prior to taking any action, it is important to obtain professional financial advice as this option won’t provide a regular income for you – or for your spouse or any other dependant after you die. Three quarters (75%) of the amount you withdraw is taxable income, so there’s a strong chance your tax rate would go up when the money is added to your other income.
Your pension scheme or provider will pay the cash through a payslip and take off tax in advance – called PAYE (Pay As You Earn). This means you may pay too much Income Tax and have to claim the money back – or you may owe more tax if you have other sources of income.
Extra tax charges or restrictions may apply if your pension savings exceed the lifetime allowance (currently £1m), or if you have reached age 75 and have less lifetime allowance available than the value of the pension pot you want to cash in.
If you exercise this option, you can’t change your mind. For many people, it will be more tax-efficient to consider one or more of the other options for taking your pension, and taking a large cash sum could reduce any entitlement you have to benefits now or as you grow older, for example, to help with long-term care needs. Not all pension schemes and providers offer cash withdrawal.
Combining your options
You don’t have to choose one option when deciding how to access your pension – you can utilise a combination of options as you like, and take cash and income at different times to suit your needs. You can also keep saving into a pension if you wish, and obtain tax relief up to age 75.
The appropriate option or combination of options that are right for you will depend on:
When you stop or reduce your work
Your income objectives and attitude to risk
Your age and health
The size of your pension pot and other savings
Any pension or other savings your spouse or partner has, if relevant
Whether you have financial dependants
Whether your circumstances are likely to change in the future