Experts Guide to Pension Drawdown
Pension freedoms enacted in April 2015 have changed the way we look at using our pensions. No longer do we assume that purchasing a lifetime annuity is the best move for everyone because other options may be equally attractive. One good example is the pension drawdown. A retirement strategy that used to be limited to a small number of pensioners with the right plans in place is now available to anyone with a workplace, SIPP, or stakeholder pension.
One of the things the industry loves most about pension drawdown is that it gives savers a lot more flexibility with their money. Along with that flexibility are new tax and death benefit rules that make drawdown more attractive now than it has been in the past. For the average pension saver, it is a matter of understanding drawdown options and how
these affect one's ability to generate retirement income.
For purposes of definition, a pension drawdown is a strategy whereby the pension saver does not convert his or her pension pot to a lifetime annuity upon reaching retirement. Instead, the money remains invested while the saver withdraws from the account as needed. If the saver's pension operator does not offer drawdown contracts, the law allows the individual to transfer to another plan that does.
As you know, the annuity is a lot different. Purchasing an annuity essentially means buying lifetime income using your pension pot. It is a less flexible option that ties up your money once the purchase is made. The annuity may be the preferred solution for people who don't want to take any additional risks with their investments, while the drawdown is a better option for those who want to continue earning on their investments even as they draw down.
Pension Drawdown Options
Prior to the new rules, there were two kinds of drawdown options available. The first was the capped drawdown; a strategy where a pensioner was allowed to withdraw up to 120% of an amount calculated annually by the Government Actuary's Department (GAD). The pensioner would enter an agreement with his or her pension operator to receive a certain amount annually up to the GAD limit.
Beginning in March 2014, the limit was increased to 150% of the government number, subject to the rules of individual schemes. Under pension freedoms, traditional capped drawdown plans are no longer available. Anyone already participating in one is allowed to continue operating under that plan according to the rules established at the onset. More on that in just a minute.
The second option prior to pension freedom was the flexible drawdown. This was a type of drawdown contract that allowed pension savers to withdraw unlimited amounts from their pension pots as they saw fit. In order to exercise this option, a saver had to have a guaranteed minimum income of £20,000 annually before taxes.
Now let's look at the options available from April 2015:
New capped drawdown contracts have not been available since 1 April 2015. However, the pensioner who already operates under one of these contracts can continue doing so as though nothing changed, with a few minor exceptions. Here are the most important points to note:
- Funds can still be added to a pension under a capped drawdown
- Existing capped drawdown contracts are subject to the current rules on income limits
- Existing contracts remains as-is as long as withdrawals do not exceed annual limits.
The last point is an important one to consider. For example, let's say you entered a capped drawdown contract five years ago and you are now taking steady withdrawals from your pot. You can continue taking up to 150% of the GAD number every year without affecting that contract. If you were to exceed the 150% limit, your contract would convert to what is known as a flexi-access plan. That plan will be explained in just a moment.
You should also know that capped drawdown contracts are reviewed every three years until the of age 75 and every year thereafter. The purpose of review is to determine the maximum income levels the pensioner can withdraw without triggering changes.
What used to be the flexible drawdown contract is now called the flexi-access drawdown. It is a drawdown contract that allows a pension saver to begin accessing pension funds at the age of 55. Like its predecessor, flexi-access allows the saver to take as much or as little as needed over a specific period of time, perhaps monthly or annually.
The saver can take up to 25% of the pension pot completely tax-free when entering such a contract. Anything over and above that amount is considered income in the year it is taken and thereby subject to the pensioner's marginal tax rate. Also note the following:
- Savers can still contribute to their pots even while drawing down
- The annual allowance is reduced to £10,000 for future contributions if taking more than 25% as a cash lump sum
- Beneficiaries of any remaining pension funds at death can continue taking drawdown payments.
The £10,000 allowance is known as the Money Purchase Annual Allowance and applies primarily to defined contribution pensions. However, members of defined benefit pensions are subject to the same annual allowances unless the rules of their contracts stipulate otherwise.
Reasons for Drawing Down
With the basics of pension drawdown now explained, you might be wondering why people would choose a drawdown contract rather than an annuity or a cash lump sum. Reasons vary just as they do with any of the other pension options. The place to start in discussing them is the fact that pension drawdown gives people access to their funds beginning at age 55.
Pensioners who choose to purchase annuities usually don't do so until they are ready to retire. For most people that is somewhere between the ages of 60 and 67. The reason for delaying is simple: annuities are essentially money purchase schemes. Once an annuity is purchased, it is a done deal; it cannot be reversed without taking a substantial loss.
Entering a pension drawdown contract allows a saver to begin accessing money even if still working. This could be done for any number of purposes, including:
- Investing the money in other opportunities
- Paying for unexpected healthcare costs
- Starting a new small business
- Paying off high-interest debts
- Satisfying an interest-only mortgage.
Consider a middle-class couple in their mid-50s with a mortgage, a small amount of credit card debt, and enough disposable income to continue contributing to their pensions above and beyond their standard contributions. This couple may choose to enter a flexi-access drawdown for the purposes of taking a 25% cash lump sum they plan to invest in securities.
This is advantageous because they can use that cash lump sum to generate higher returns than they would get if they left it in their pension. In the meantime, they will continue contributing to their pension pot through their workplace contributions and the additional disposable income they have. Provided their securities investments work out, they will likely end up with more money in the long run.
Another common scenario is entering a drawdown for the purposes of taking annual payments to provide supplemental income while the individual is still working. Though doing so is not always the wisest choice, it is a possibility nonetheless. Pensioners who choose to do so should understand that every withdrawal means their pension pot has less money by which it can earn returns.
This reality suggests that not every reason for accessing pensions beginning at age 55 is a good reason. Before someone enters a flexi-access drawdown, he or she should be thoroughly versed in every option. Flexi-access drawdown certainly has benefits that shouldn't be ignored. But there are also significant risks to be considered as well.
Tax Issues with Drawdowns
There are always tax implications when talking about pension access and retirement income. Flexi-access drawdowns are no exception. Of all the factors that influence pension decisions, taxation is the most important because it involves turning over some of the money you have earned to the government.
Prior to pension freedoms, drawdown contracts were not the norm among average workers. The tax implications of those former contracts were such that they were less attractive than annuities to most people. That's no longer the case. With that said, there are couple things to note about taxation and drawdowns.
As previously stated, any cash lump sum of up to 25% can be taken at the start of a pension drawdown contract completely tax-free. That amount of money will not be subject to income tax, capital gains tax, or any other taxes. Clearly, this is the greatest tax advantage of a drawdown strategy.
Anything taken over and above that 25% is subject to the following two consequences:
- Income Tax – Excess withdrawal income is added to the recipient's regular income and taxed at the marginal rate for that year. It is entirely possible that a saver already on the upper limit of his or her current tax band could be pushed into a higher tax band by taking more than the 25% allowance.
- Annual Allowances – Taking more than 25% automatically subjects any additional contributions to the £10,000 annual allowance. Anything contributed above that amount would be subject to normal income taxes.
The last thing to understand is the income tax that applies to the regular amounts taken over the life of a drawdown contract. All of that income is considered standard income in the years it is received. That means the payments you are receiving five or 10 years after your drawdown contract began are considered income. It will be taxed at your marginal rate.
Death Benefits with Drawdown
Flexi-access drawdown contracts offer attractive death benefits that make them worth considering. Should you die at any point up to age 75 with funds is remaining in your account, any lump sum taken by your beneficiaries will be tax-free. Lump sums taken in the event you die after age 75 are subject to income tax.
Regardless of your age at death, your beneficiaries will have the choice of continuing to take withdrawals based on the original contract rules (until all payments have been taken) or accessing the money via a lump sum payment. Beneficiaries obviously need to take their own tax positions into account when deciding how to proceed.
Ask for Help
Drawing down your pension beginning at age 55 may turn out to be a wise financial decision for you. The new pension drawdown rules allow you to use your pension as you see fit, rather than being automatically drawn into an annuity purchase. You now have the flexibility the rule changes were designed to afford you. That's good.
Before making any pension drawdown decisions, we urge you to ask for some help. Our panel of FCA regulated pension experts can provide that help by way of sound financial advice. Our initial consultation is free, so you will not pay a pound to learn what the best options for you are. We will always advise you of any charges before you commit to investing in any of the products or services we off.
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