Drawing money flexibly from your pension, known as income drawdown or flexi-access drawdown, allows you to take up to 25 per cent of your pension pot tax-free from age 55 onwards, and to either draw down the remaining 75 per cent as taxable income or keep it invested for later access. For example, an investor with a fund of £100,000 could take £25,000 as a tax-free lump sum and access the remaining £75,000 as drawdown when they like.
But depending on the amount you withdraw and the way you take it, you could find yourself paying more tax and receiving less money than you expect. So make sure you don’t make the following mistakes.
Taking a large taxable withdrawl
Taking anything over the tax-free amount from one or more of your pension pots may push you into paying a higher rate of tax. This is because pension income is treated as earned income for tax purposes, so your withdrawals over the tax-free 25 per cent will be added to the rest of your income for the tax year.
| Income tax bands 2017/18 | |
| Band | Income per year over personal allowance (£) |
| Basic rate - 20% | 0 - 33,500 |
| Higher rate - 40% | 33,501 - 150,000 |
| Additional rate - 45% | Over 150,000 |
| Source: HM Treasury | |
| Individual allowances 2017/18 | |
| Allowance | Annual amount (£) |
| Personal | 11,500 |
| Income limit for personal* | 100,000 |
| Dividend | 5,000 |
| Source: HM Treasury *reduced by £1 for every £2 of income over income limit. Personal allowance is exhausted when income exceeds £123,000 | |
In the worst-case scenario, you could become a top-rate taxpayer if you make a pension pot withdrawal that, combined with your other income, takes you over £150,000.
Putting tax-free cash in the bank
Think carefully about what you want to do with the tax-free money you withdraw. “Many people access their pension with a specific purpose in mind, but there’s a significant group who just put the money in a bank account,” says Richard Parkin, head of pensions policy at Fidelity International. “This creates several tax issues. Once in the bank any returns are subject to tax, any bank deposits count towards your estate for inheritance tax (IHT) purposes and it can impact entitlement to certain state benefits.”
| Savings tax rates 2017/18 | |
| Rate | (%) |
| Basic rate | 20 |
| Higher rate | 40 |
| Additional rate | 45 |
| Source: HM Treasury |
Breaching your allowances
You can earn up to £11,500 in the 2017-18 tax year before paying any tax. But this personal allowance is whittled away by £1 for every £2 that your adjusted net income is above £100,000. This means that if your income is more than £123,000 your personal allowance will be zero.
Taking a large taxable withdrawal via income drawdown can push your income above the £100,000-a-year threshold, reducing your personal allowance and increasing your tax bill. Or if you currently pay no tax because your annual income is less than the personal allowance of £11,500, taking a withdrawal may push you into paying tax.
As well as avoiding these mistakes, there are a number of steps you can take to help you take your income drawdown tax-efficiently. “This new pension world is about looking at all assets to provide retirement income in the most tax-efficient way,” says Jonathan Watts-Lay, director at financial education company WEALTH at work. “It is important to use your available tax allowances and reliefs in a structured manor to maximise returns and reduce, or even eliminate, a potential tax charge.” So consider doing the following:
1. Draw tax-free cash in phases
You don’t have to take your tax-free cash all at once. “You can stagger this and take out bits of your entitlement in stages,” says Mr Parkin. “This ultimately means leaving more invested and growing more tax-free cash for the future.”
And drawing your tax-free cash over a number of years rather than in one go means you are able to benefit from using your annual allowances to take income out of your pension more tax-efficiently. “For example, an individual could use £20,000 of their pension pot, taking £5,000 as a tax-free lump sum and putting £15,000 into a drawdown fund,” explains Jon Greer, pensions technical manager at Old Mutual Wealth. “Assuming they did not have any other taxable income in that tax year, they could take up to the personal allowance from the drawdown fund without any tax deduction. Any amount they take from their drawdown fund in excess of their available personal allowance would be subject to income tax.”
2. Take income from other assets
Being able to draw on a range of assets, such as individual savings accounts (Isas) and cash, in addition to your pension will help you generate an income more tax-efficiently.
“If you have other sources of income, only withdraw income from your pension when you need it,” says Danny Cox, chartered financial planner at Hargreaves Lansdown. "If you wanted to minimise tax you could draw money from Isas rather than your pension, as Isa income is tax-free. But after the 25 per cent lump sum, pension income is taxable. Leaving your pension alone means it continues to grow as you're not taking income from it."
Unlike Isas, pensions can be passed on to your heirs completely free of IHT if you die before age 75. If you die after 75, the pension will be taxed at your beneficiaries’ income tax rate. But if you pass on an Isa your heirs may have to pay a 40 per cent IHT charge if your estate is worth more than £325,000.
Drawing from other assets, such as dividends you hold within non-Isa accounts, can also contribute to tax-free income. Basic-rate taxpayers can earn up to £5,000 in dividends from their investments before paying any tax.
| Dividend rates 2017/18** | |
| Band | (%) |
| Ordinary rate | 7.5 |
| Upper rate | 32.5 |
| Additional rate | 38.1 |
| Source: HM Treasury **payable above the £5,000 tax-free Dividend Allowance | |
Plan ahead
As well as thinking about how best to minimise tax when making income withdrawals, it also makes sense to remember the basics of managing your pension pot: keep some cash aside as an emergency contingency fund, don’t breach the pension lifetime limit of £1m and make sure the level of income you withdraw is sustainable. A good rule of thumb for how much to withdraw so as not to deplete your pot is about 4 per cent, according to Mr Cox.
Examples of how to take income drawdown tax efficiently
Peter, age 60
Peter is 60 and has a defined-benefit (DB) pension (final-salary pension), which will pay £8,000 a year, a defined-contribution (DC) pension fund worth £300,000, Isas worth £50,000 and cash worth £10,000. He plans to retire in April 2018 and would like to generate an initial net annual income of £20,000 a year and retain the £10,000 cash as an emergency reserve.
He can do this without paying any tax in year one, even though £20,000 is almost double the personal allowance of £11,500 for 2017-18, by using his Isa and flexi-access drawdown for income.
Peter can withdraw £2,500 interest from his Isa. He has a personal allowance of £11,500, so does not need to pay tax on the £8,000 from his DB pension, and still has £3,500 of unused allowance available.
He needs a further £9,500 to have a £20,000 income. To be able to do this he will need to crystallise £24,000 of his DC pension using flexi-access drawdown – £6,000 (25 per cent) can be taken as a tax-free cash lump sum and £3,500 withdrawn as an income, offset against his remaining personal allowance of £3,500.
By doing this he will have the £20,000 he is looking for tax-free. £18,000 will remain in his pension as a crystallised fund with the potential to grow and which can be drawn in future years.
Mary, age 63
Mary is 63 and plans to retire in April 2018. She is in exactly the same financial position as Peter, but is also eligible for the full new state pension of £8,296.
Mary’s combined income of £8,000 from her DB pension and £8,296 state pension gives her a gross income of £16,296. As the combined income from her DB scheme and state pension will be higher than the personal allowance of £11,500, she will need to pay some income tax. This will total £959, leaving her a net income of £15,337. But she will not need to pay any further tax up to the £20,000 annual income she is aiming to achieve.
That’s because she can supplement her income with £2,500 interest from her Isa and £2,163 tax-free cash from her DC pension fund. To do this she would need to crystallise £8,652 using flexi-access drawdown, £2,163 (25 per cent) can be taken as a tax-free cash lump sum and £6,489 would remain as a crystallised fund in her pension with the potential to grow.
David, 60
David is 60 and plans to retire in April 2018. He has a DB pension that will pay £8,000 a year, a DC pension worth £200,000, Isas worth £50,000 and taxable cash deposits of £100,000.
To get an income of £20,000 a year tax-free, he could offset the £8,000 from his DB pension and £3,500 from the taxable part of his DC pension fund against his personal allowance of £11,500. He would need to crystallise £4,667 of his pension to be able to withdraw £3,500 (75 per cent) in taxable income and £1,167 (25 per cent) would be paid as a tax-free cash lump sum (£3,500 + £1,167 = £4667).
This could be supplemented with £2,500 interest from his Isa and £1,400 interest from his savings, which would not be taxed because the starting rate for savings income is £5,000. As it is better to leave as much money as possible in tax-efficient Isas and pensions, David could spend £3,433 from his cash deposit to make up the £20,000 he is looking for.
Source: Wealth at work. All these examples show individuals paying the lowest amount of possible tax and keeping their Isas and saving accounts at the same level (assuming Isa growth rate of 5 per cent a year and interest available on cash deposits of 1.4 per cent gross a year).
