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.
How pension drawdown works
In drawdown, you are in control of your income. You can choose to make regular withdrawals, dip into your pot whenever you need to, or even take out the whole pension in one go.
You can also withdraw up to 25% of your pension as a tax-free lump sum. The rest of your pension withdrawals will be taxed as income at the marginal rate.
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 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.
Drawdown pros and cons
- Your money could continue to increase in value while invested
- You take whatever level of income you need, when you need it
- You can manage your annual tax liability
- Your pension can be passed on in death, normally free from inheritance tax
- You could run out of money
- Your pension value could fall if share prices fall
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 2021/22 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 income 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 income.
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.
Pension drawdown FAQs
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Please remember, SIPPs are aimed at people happy to make their own investment decisions. Investment value can go up or down and you could get back less than you invest. You can normally only access the money from age 55 (57 from 2028). We recommend seeking advice from a suitably qualified financial advisor before making any decisions. Pension and tax rules depend on your circumstances and may change in future.