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In our weekly series, readers can email in with any question about retirement and pension savings to be answered by our expert, Tom Selby, director of public policy at investment platform AJ Bell. There is nothing he does not know about pensions. If you have a question for him, email us at [email protected].
Question: I’m about to turn 64 and plan to access my pension for the first time in the next 12 months. I’m probably going to opt for drawdown, but I’ve read that I can also take lump sums from my pot. Is there a big difference? If so, what are the pros and cons?
Answer: Savers with “defined contribution” (DC) pensions have total flexibility over how they access their retirement pot from age 55. This minimum access age is due to rise to age 57 in 2028.
Most people with DC pensions are entitled to a quarter of their fund tax-free, with total tax-free cash over your lifetime limited to £268,275. All other withdrawals are subject to income tax.
In order to access your tax-free cash, you need to choose a retirement income route for the rest of your fund. There are two main ways you can take an income from your DC pension: via drawdown, and buying an annuity (a guaranteed income paid by an insurance company).
Drawdown is simply a flexible way of accessing your pension pot while keeping your money invested for the long term. This allows you to build a retirement income plan to suit your needs and circumstances by tailoring your investments and withdrawals.
Alternatively, if you choose not to take all your tax-free cash upfront you can take lump sums from untouched funds (referred to in the jargon as “uncrystallised funds pension lump sums” or UFPLS) with a quarter of each lump sum tax-free and the rest subject to income tax. The same £268,275 limit applies to your overall tax-free cash entitlement when you access your pension in this way.
This method of accessing your pension was primarily introduced so people in schemes that don’t offer drawdown could still access their fund flexibly. The main difference is that drawdown is geared more towards people taking a regular income, while UFPLS is more likely to be used for single lump-sum withdrawals.
However, it is perfectly possible to take a single drawdown withdrawal using only a portion of your fund (with a quarter available tax-free), or conversely to take regular lump sum withdrawals (as long as your pension provider allows this).
The main pros and cons of drawdown and lump sums are therefore similar. Both offer you total flexibility over how you access your fund, meaning you can create a withdrawal plan that suits your needs and lifestyle.
Since your fund remains invested until needed, there is the potential to benefit from long-term investment growth. It is also simple to switch provider to get the best deal – you’ll just need to give your chosen provider a few details and they’ll do all the legwork for you.
In addition, the death benefits regime is attractive. If you die before the age of 75, it is possible to pass on your fund completely tax-free to as many nominated beneficiaries as you like.
If you die after the age of 75, any leftover funds will be taxed in the same way as income when your nominated beneficiary (or beneficiaries) makes a withdrawal. Crucially, your pension should not count towards your estate for inheritance tax (IHT) purposes.
All this flexibility does come with risks you will need to manage. In particular, you need to make sure you are not taking too much, too quickly from your fund, as this runs the risk of leaving you short of money in your later years. Making large withdrawals from your pension could also see you pay more income tax than is necessary.
As well as managing your withdrawals sustainably and tax efficiently, you need to be comfortable taking investment risk with your fund. All of this means that both of these methods of accessing your pension are “hands-on”, requiring regular engagement.
You should be aware that in most circumstances when you access your pension flexibly for the first time, either via drawdown or by taking lump sums, you will be overtaxed by HMRC.
If you are taking a regular income or regular lump sums then the Revenue should adjust your tax code to even things out over the tax year, but if you’re taking a single withdrawal you may need to complete a form to get your money back.
I covered this issue and the process of reclaiming your pension in detail in a previous column.
The other main retirement income option is buying an annuity. This takes investment risk off the table, provides income security and means you don’t have to engage with your pension.
The main downside of annuities is they are inflexible and by locking into a product for life, you forgo the potential to benefit from long-term investment growth or vary your income as your circumstances change.
One thing to remember is that these are not binary options. For example, you could use a portion of your fund to buy an annuity while taking a flexible income with the rest via drawdown or lump sums.
They key is to build a plan that suits your needs. If you are at all uncertain about this, you might want to consider paying a regulated financial adviser to help. If you don’t want to go down this road, the government-backed Moneyhelper website has lots of useful information.
