Pension Withdrawal Options

How to use your pension pot is an important decision which should not be taken lightly. It is important not to rush your decision making and to fully understand and contemplate the various options available.

Following pension reforms made in April 2015, the British public have significantly more freedom when deciding how and when to utilise their pension savings.  

From this point on, anyone aged 55 or over could access their Defined Contribution pension schemes and could choose from five different withdrawal options (or a mixture of some/all options).

The five pension withdrawal options

Leave pension untouched, letting it benefit from tax-free compound growth

If you don’t immediately need to withdraw your pension, you are perfectly entitled to continue to let it grow. If you leave your pension untouched, no tax will fall due until you reach age 75, when a benefit crystallisation event takes place. At this point, your pension pot will be subject to a Pension Lifetime Allowance test and it may be necessary to pay a tax charge based on any excess over the allowance in place at the time.

Using your pension pot to purchase an annuity (guaranteed income for life)

You can withdraw up to 25% of your pension pot tax-free (up to the Pension Lifetime Allowance, which most people do not exceed) and then use the remaining balance to purchase an annuity. An annuity provides a guaranteed level of income for the rest of your life, irrespective of how long you live.

There are two types of lifetime annuity: basic and investment linked. A basic annuity provides a set level of income whereas an investment linked annuity provides a varied level of income based on underlying investment performance. An investment linked annuity is however subject to an income floor (i.e. an agreed minimum level of income).

Any income received via the annuity is taxed normally.

It is possible to purchase an annuity which also provides cover for any dependent or nominated beneficiary for a set period after your death.

Given annuities provide a guaranteed income for life, the older you are at the point at which you purchase, the higher the annuity rate (income) you’ll receive. The annuity provider (without explicitly telling you) essentially makes an estimate of how long you will live based on historical data. Using this same logic, enhanced annuity rates are available through some providers if you have a medical condition, are overweight or have smoked.

The income available via annuities is often lower than the income you may project to receive via pension drawdown. However, it is a lower risk option since income is guaranteed.

Another important point to note is that unless you opted for an annuity with specific features (e.g. value protected annuity, a ‘guarantee’ period, or with set payments to a beneficiary for a fixed number of years), your pension benefits will cease when you die. This means that your beneficiaries will not inherit anything in relation to your pension funds.

Put your pension into ‘pension drawdown’ (flexible retirement income, not guaranteed)

You can withdraw up to 25% of your pension pot tax-free (up to the Pension Lifetime Allowance, which most people do not exceed) and then use the remaining balance to invest in funds which are designed to provide you with a regular taxable income.

The key difference between pension drawdown and an annuity is that there is no guaranteed level of income with pension drawdown. The level of income you receive will depend on the performance of the underlying funds whilst the capital value of your investment is also subject to change.

Income can be withdrawn from the funds as and when it suits you.

If opting for this pension withdrawal option, it is important that you carefully manage your funds to ensure that you do not run out of money in retirement.

A common rule of thumb is that if you withdraw 4% of your total pension pot during your first year of retirement and then adjust that by inflation in each subsequent year, you should not risk running out of money for at least 30 years.  

Unlike when you purchase an annuity, pension pots do transfer to beneficiaries upon death.

Age on deathTax rules
< 75Pension pot passes tax-free to beneficiaries provided the money is paid within two years of death. However, note that a benefit crystallising event takes place on death – see Lifetime Pension Allowance article.
> 75Pension pot is taxed at the beneficiary’s marginal rate of income tax.

Withdraw small cash sums when required

The key difference between this option and the drawdown option is that your pension is not re-invested into new funds which are specifically designed to pay a regular taxable income.

There is also an important tax distinction, as a benefit crystallising event takes place each time you decide to withdraw cash from your pension pot, rather than one benefit crystallising event taking place at the point of pension drawdown.

Unless you have exceeded the Pension Lifetime Allowance, the first 25% of each cash withdrawal is tax-free with the rest counting as normal taxable income. Cash withdrawals can be made as and when required.

Again, if opting for this pension withdrawal option, it is important that you carefully manage your funds to ensure that you do not run out of money in retirement.

When you opt for this pension withdrawal option, pension pots do transfer to beneficiaries upon death. The same rules apply as per the pension drawdown:

Age on deathTax rules
< 75Pension pot passes tax-free to beneficiaries provided the money is paid within two years of death. However, note that a benefit crystallising event takes place on death – see Lifetime Pension Allowance article.
> 75Pension pot is taxed at the beneficiary’s marginal rate of income tax.

Withdraw the full pot as cash

Finally, you can opt to withdraw the full balance of your pension pot in cash.

You can withdraw up to 25% of your pension pot tax-free (up to the Pension Lifetime Allowance, which most people do not exceed). The remaining balance of the withdrawal will be taxed at your highest tax rate because it is treated as income.

Before cashing in your entire pension pot, be sure to get independent financial advice. This is important because the tax bill is likely to be material and your cash (unless wisely invested) will not provide you with a secure retirement income.

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