Pension drawdown explained

What is pension drawdown?

Pension drawdown is a flexible way of taking money out of your pension once you turn 55 (57 from 2028). 

It can be considered an alternative to an annuity, which is less flexible but guarantees a fixed income.

With drawdown, your pension stays invested. The benefit is that your pot could see investment growth and higher future returns while you control how much you take from your pension. On the other hand, your pension value could fall if share prices drop.

- Capped drawdown

If you went into drawdown before the wide-ranging pension reforms on 5 April 2015 and have not converted to a flexi-access drawdown, then you will be in capped drawdown.

This means you are subject to a limit on the maximum amount you can take as income from your pension pot.

This capped drawdown limit, set by the Government Actuary’s Department (GAD), is roughly 150% of the annual income that a basic annuity would give you. The limit is reviewed every three years, and then annually after you turn 75.

You can convert from capped drawdown into flexi-access drawdown. However, you will lose the benefit of a standard annual contribution allowance (up to £40,000), and will be subject to the Money Purchase Annual Allowance (MPAA) of £4,000.

- Flexi-access drawdown

Flexi-access drawdown replaced flexible drawdown in April 2015 and since then has been available on all new drawdown products.

Flexi-access allows you to withdraw you pension savings whenever you need to while keeping the rest of your pot invested.

How much tax will you pay in drawdown?

The first 25% of your pension pot can be taken tax-free. This can be as a lump sum or smaller withdrawals. The rest of your pension will be subject to normal income tax rates:

The first £12,500 is tax-free. 

• 20% tax on the next £37,500 above this.
• 40% tax on everything above £50,000 (£12,500 + £37,500) 
• 45% tax on everything above £150,000.

These figures apply to income tax in England, Wales and Northern Ireland in the 2020/21 tax year. Income taxes in Scotland are different.

What is the lifetime allowance?

The lifetime allowance is the limit on the amount you can withdraw from your pension without extra tax charges. The allowance for the 2021/22 tax year is £1,073,100. 

Any savings above this limit will be subject to tax at 55% if it is taken as a lump sum or 25% if taken as income (plus this will also be subject to income tax when paid).

Tax relief and the Money Purchase Annual Allowance (MPAA)

After you start taking money from your pension, you are still allowed to make contributions, but the maximum amount you can pay in and claim tax relief on reduces from up to £40,000 to £4,000. 

This is known as the Money Purchase Annual Allowance and is only triggered when you start taking flexible pension payments.

Month 1 tax

When you start taking income from your pension, your provider will give you a tax code. If they do not, you may be charged a ‘Month 1’ tax, or an emergency tax, which can be quite high.

You will be able to claim this money back from HMRC directly – or, if taking regular income, this will correct itself once HMRC provide an up-to-date tax code.

What happens to your pension drawdown plan when you die?

In the past, pensions used to be taxed 55% before being passed on to your beneficiaries. Thankfully, this has been reformed.

Under the age of 75

If you die under the age of 75, there is zero tax to pay on your remaining pension which can be taken out as income or as a lump sum.

Over the age of 75

If you die over the age of 75, your beneficiaries will pay tax at their marginal rate of income tax, whether they chose to take the pension as income or as a lump sum.

Recent reform allows you to leave your pension to anybody you choose. It is important that you complete your pension provider’s ‘expression of wish’ form to note who you would like to inherit your pension.