How to Make the Most of Your Drawdown Pension
Pension drawdown as a retirement strategy involves gradually withdrawing money from your pension pot rather than purchasing a lifetime annuity. It is a strategy that has been available in the UK since the 1990s. In the past, it has been an unattractive strategy for average savers because of its restrictions and tax implications. But pension freedoms implemented in 2015 have changed all that.
Pension drawdown is now more attractive thanks to its implicit flexibility. Today's flexi-access drawdown contracts give savers more options and fewer tax liabilities – as long as proper planning takes place. This suggests that pension savers should at least consider drawdown as they get closer to retirement age.
Bear in mind that flexi-access drawdown includes the option to begin accessing pension funds at the age of 55. That was impossible under the old rules. That means you can now take a lump sum payment at age 55 if you so choose, you can enter a drawdown contract right away, or you can utilise a strategy combining both.
The purpose of this guide is to help you understand how to make the most of a pension drawdown under the new rules. If you already participate in a capped drawdown or an older flexible drawdown contract, you can continue operating under that contract as-is with no significant changes. There may be some changes to future contributions, so consult a professional if you are under an old contract and planning to contribute more than £10,000 to your pension pot in any given year.
Understand the Value of Your Pension
The first step in making the best use of a drawdown pension is understanding the real value of your current pension pot. In other words, its cash value at this current time should go up due to the scheme's investments if you leave the money alone. In theory, your pension pot should continue to grow as long as you don't withdraw. Why is this important? Because every withdrawal reduces your earning potential.
You need to look at your current pension pot and compare it to your life expectancy at the time you retire. Will the amount you have saved provide sufficient retirement income if nothing else changes? There is no way to know for certain, but coming up with a relatively stable assessment could mean the difference between having enough money and running out before you die.
The need for understanding the value of your pension is one of the reasons we constantly recommend working with a certified financial adviser. Professionals have the knowledge and experience to offer stable estimates along with options for creating effective retirement strategies.
Consider Your Lifestyle
Once you understand the value of your pension pot, you must then consider the kind of lifestyle you want to lead once you stop working. For example, do you plan to continue living just as you live now? If so, your plans can be based on your current income and expenses adjusted for estimated inflation.
On the other hand, you may want to use your retirement years to do things you weren't able to do while working. You may want to:
- travel extensively
- become a more active investor
- retire overseas
- take up a new hobby
- get involved in volunteering.
Your lifestyle choices will largely determine how much income you need in retirement. A more comfortable lifestyle will require more aggressive withdrawals that will deplete your savings and its earning potential proportionally. You must remember that such depletion will affect future income. Even if the growth of your pension scheme remains constant over the next 5 to 10 years, your individual return will be lower in real terms as a result of every withdrawal you make.
It helps to have at least a basic understanding of your desired lifestyle in retirement so that you can begin putting away money now. A good rule of thumb is to save that amount of money equal to half your age at the time you start pension investing. So if you start saving at age 25, the minimum to put away annually is 12.5% of your income. Bear in mind that this level of saving will likely result only in having enough income to live at your current lifestyle. If you want a more comfortable lifestyle, you have to save more.
Consider Your Aversion to Risk
A drawdown pension is certainly not without risks. In light of that, making the best use of your pension via a flexi-access drawdown requires you to consider your own aversion to risk. Do you want to virtually guarantee that you will not run out of money and that your pension will maintain some earning potential? If so, your drawdown contract should be structured very conservatively.
On the other hand, you may be willing to accept a greater level of risk in order to enhance your lifestyle or increase your earning potential. In such a case, you might consider taking a substantial lump sum and investing it in opportunities known to perform better than your current pension scheme. You might also be willing to take the risk of running out of money in order to enjoy a more comfortable lifestyle. It's entirely up to you, but make sure any decision you make is only made after receiving sound advice.
Always keep in mind that a drawdown pension is subject to complete depletion before you die. That is the nature of drawing down. If you can live entirely on drawdown income during the early years of retirement, you may want to consider deferring your state pension during that time. Deferring will result in higher payments when you do begin collecting.
Consider Your Tax Position
Making the best use of a drawdown pension involves yet another important factor: your tax position. Assuming you do not exceed annual allowances while contributing to your pension pot, you benefit from being able to put money away free of income taxes. That's a very good thing. The government allows for tax-free pension savings in order to encourage people to prepare for retirement. But once you begin drawing out of your pension, taxes come into play.
Entering a drawdown contract will afford you the opportunity to take a lump sum cash payment from your pension pot. If that lump sum equals 25% or less of your total pension pot, no income taxes will be applied. You can use that money to invest elsewhere, pay off other debts, or whatever. If you take more than 25%, the difference will be subject to income tax. Furthermore, your annual drawdown income after the 25% limit has been reached will be taxed at your marginal rate.
The point of telling you this is to encourage you to consider your tax position before you start drawing down. The goal is to limit your tax liabilities as much as possible. Any income you receive from your drawdown over and above the 25% could push you into a higher tax band when combined with other income. This is especially important if you will be drawing from your pension while you continue working.
One last thing to consider is this: should you exceed the 25% limit within the first year of your drawdown pension, any future contributions you make to your pension pot will be subject to the £10,000 annual allowance. Contributing over and above that allowance is not tax-free. That amount of money will still be counted against your income and taxed accordingly.
Learn All You Can
As you can see, making the best of a pension drawdown strategy requires you to consider a lot of different things. The best advice we can offer is that you learn all you can about how drawdown works and what your options are based on your current age and your future retirement plans.
There are a number of government and charity websites you can look to for information about flexi-access drawdown, lump sum payments, taxation, and so on. You can also seek advice from charities and government-approved organisations specialising in retirement planning. Finally, you can get advice from a certified financial adviser. We recommend getting as much advice as you possibly can. You can never go wrong by learning more about your options.
For example, do you know what to do if you attempt to enter a drawdown contract only to find out your pension operator doesn't offer one? A certified financial adviser could explain your options for transferring. Yes, you can transfer your pension into a new scheme allowing for drawdown rather than leaving it where it is. These are the kinds of things you need to learn about in order to make wise decisions.
You need to learn all you can about:
- tax implications and liabilities
- your investment options
- current returns on your pension
- pension transfer options
- making future pension contributions
- death benefits associated with drawdown
- the differences between drawdown and annuities.
We all know the old adage that says knowledge is power. It certainly applies to pension drawdown and, more broadly, pension investing and retirement. The more you know about your potential and your options, the better prepared you will be to make good decisions.
Create a Plan and Implement It
The final key to making the best of a drawdown pension is to create a plan and then implement it. A sound financial plan is based on a combination of current factors and future projections. Bear in mind that no retirement plan can be 100% accurate and reliable. Furthermore, a good financial planner will tell you that adjustments have to be made as time goes on. This is normal.
You need to come up with a plan as early in your working career as possible. Younger workers have more options because they have more time to put away what they need. Older workers are more limited. But know this: you are never too old to establish a retirement plan. You are never too old to begin putting money away for retirement.
In terms of a pension drawdown, your plan may involve using some of the money in your pension pot to supplement your monthly income before you begin drawing the state pension. Such a case would require you to plan for losing earning potential for every year you withdraw. It might suggest taking larger amounts now, then withdrawing less as state pension payments begin.
This is just one example of the kind of planning required when exercising pension drawdown. There are far too many scenarios we could describe to be able to adequately address them all in this guide. The point is that you need a plan. Failing to plan is essentially planning to fail. And that is something you cannot afford in terms of your retirement.
Free Expert Help and Advice
If you need expert help with any pension issue, please do not hesitate to contact our friendly team of FCA-regulated pension advisers. Our carefully selected panel of pension experts offer initial pension advice free of charge. Should you decide to act on their advice, you will be made aware of the full costs and financial implications before you make any commitment to proceed.
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