As you approach retirement, you will need to consider how to replace income from work with alternative sources, like pensions. Traditionally, you would take your tax-free lump sum, worth up to 25% of the pension fund. You would then use the remaining fund to provide a taxable guaranteed income for life, called a pension annuity. Now, you can take income using flexible pensions, so this gives many more opportunities for tax-free pension withdrawals. With some careful financial planning, you can use flexible pensions to minimise tax, and maximise your income.
Of course, the tax you pay on your pension withdrawals is only part of the story. You should consider many other aspects when taking withdrawals from your pension, which is why we recommend that you take financial advice from a pensions expert.
- The 2 main choices for pension income
- Using flexible pensions for tax-free pension withdrawals
- How pensions are taxed
- Sarah’s 4 options for tax-free pension withdrawals (plus 2 options where she pays tax)
- General principles for tax-free pension withdrawals
The 2 main choices for pension income
There are a wide variety of solutions available for you when taking pension withdrawals. Here we explore the 2 main pension income options, for comparison.
Guaranteed pension annuity – the traditional pension income
This is the traditional way to take an income from your pension plan. You would choose this pension income method if you want certainty over your income, no matter what happens. A guaranteed pension annuity allows you to swap your pension fund for a guaranteed, taxable income for life. You get to choose the tax-free lump sum you want, and then invest the remaining fund into the pension annuity. The income will be set up according to the features you choose, but the main choice is whether you want your income to start higher at first, but never to increase; alternatively, your income can start lower, but increase annually in line with inflation, or a constant growth rate. A pension annuity is still the right choice for many people, since it can provide you with a guaranteed income for life. The main benefit is certainty, but the downside is that you do not get to change your income once the plan it set up. In addition, unless you pay for extra benefits, the income will die with you. In addition, the only way you can use an annuity for tax-free pension withdrawals is to take the tax-free lump sum.
Using flexible pensions for tax-free pension withdrawals
The flexible pension rules allow you to treat your personal pension more like an ISA, once you reach age 55. The complex pension rules still exist, but you can now withdraw as much as you want, subject to tax, at any stage. This is very useful if you want control and flexibility, and are prepared to take some risk over your future. Flexible pensions work well if you have some other sources of income, and you do not need guaranteed income. You can also pass on your remaining fund to your family after you die. The downside is that flexible pensions are more complex. You take risk with your investments, and also that you might outlive your fund (run out of money).
How pensions are taxed
If you understand how pensions are taxed, you can start to see how you can take tax-free pension withdrawals. Looking at the table above, pensions are taxed differently depending on the 3 stages outlined:
- Contributions When you pay money into your pension plan, you benefit from tax relief. For most savers this means that £1 is boosted to be £1.25. This is one of the major benefits of pension plans.
- Accumulation stage While your pension fund is growing, it is tax-free. This is a major benefit, and puts pensions ahead of most investments, which are taxable. This is known as “uncrystallised benefits” in technical terms.
- Income stage When you start to take money out of your pension, it can become taxable. You can get 25% of the fund as a tax-free lump sum. The remainder of the fund is potentially taxable against income. This is known as “crystallised benefits” in technical terms.
- Annual allowance You should be careful when taking pension withdrawals. As soon as you take a taxable pension withdrawal your annual allowance for pension contributions will reduce to a maximum of £4,000 per tax year.
The strategies in this article are concerned with using the flexible pension rules to allow for tax-free pension withdrawals. You can now access new ways of tax-free pension withdrawals because the flexible pension rules allow you to split the fund across the accumulation stage and the income stage.
This article is intended to show how and why you should consider different ways to take your flexible pension benefits. Of course, the income decisions from pension plans can be complex, and you should consider additional issues like the lifetime allowance, drawdown emergency tax. We have not considered these issues for this article as it would make it more complex, and take you away from the main points of the article.
Sarah’s pension fund
For the purpose of this article we have used a pension fund valued at £300,000 to show the strategies set out below. In each scenario, Sarah is assumed to have different needs, which highlight why she might use each of the strategies. Sarah is aged over 55, so she can access her pensions flexibly.
Option 1 – full withdrawal
When Sarah hears about flexible pensions, she thinks “Great, I just want my money.” This is an understandable reaction. Most people see that their pension plans are inaccessible for many years, and now that they can get their hands on the fund, many want to see the money in their bank account – after all the money is theirs. However, this ignores that the pension money is accessible at any stage from age 55. Therefore, you can think of your pension fund at more like an ISA from age 55. Just because it is accessible, does not mean you should access the money. If Sarah accesses her full pension fund, not only will she pay income tax on her withdrawal, but she will also start paying tax on the remaining fund in her bank account.
When Sarah moves from the accumulation stage to the income stage she can take 25% of her fund as a tax-free pension withdrawal, which is £75,000. The remaining 75% is taxable against her income. Assuming she has no other income for the tax year, she will pay £87,050 in income tax. The total of her fund paid out is £212,950. Clearly, this is not the most tax-efficient use of Sarah’s money.
Sarah’s pension fund is completely exhausted using this option. She has paid 29% of the fund in tax, and will now attract additional tax on wherever she places the fund.
Why would Sarah choose option 1?
The only reason Sarah might choose this option is if she has a need for a large amount of capital, and has no other source of funds.
Option 2 – Full tax-free lump sum
This option was always available, even before flexible pensions. Under this option, Sarah would move all of her pension fund from the accumulation stage into the income stage. Sarah can then take a tax-free pension withdrawal as 25% of the fund. The remaining fund could be left invested in the income stage, and would continue to grow tax-free.
Under this option Sarah would withdraw £75,000 tax-free, and leave £225,000 invested tax-free in her pension. Any future withdrawals would be taxable.
Why would Sarah choose option 2?
Sarah might choose this option if she needs access to capital to spend – perhaps to pay off a debt. She should not use this option if she does not need the full tax-free lump sum. If Sarah does not spend the tax-free lump sum she will start to pay tax on the withdrawal once it is placed outside of the pension plan. If Sarah does not need all this money, she would be better to leave it invested tax-free in the pension plan, and to withdraw it later, when she needs further funds.
Option 3 – partial tax-free lump sum
If Sarah needs a smaller tax-free lump sum, she can split her fund into 2 to allow her to access part of her fund. This would then preserve the remainder for future tax-free pension withdrawals. Let’s assume Sarah needs £40,000 to pay off her mortgage. She would move £160,000 from the accumulation stage to the income stage. She can then take 25% of her income stage fund as a tax-free lump sum, paying £40,000 into her bank account.
Once the transaction is complete, the remaining £260,000 is left in her pension plan to grow tax-free. £140,000 would still be in the accumulation stage (and could generate further tax-free withdrawals later); £120,000 would be in the income stage, and would be subject to income tax if withdrawals are taken from this part.
Why might Sarah choose option 3?
Sarah might choose this option if she needs access to capital to spend – perhaps to pay off a debt. She would withdraw the amount she needs to spend on paying off her debt, but leave the maximum amount remaining in her pension plan, to grow tax-free.
Option 4 – tax-free income
If Sarah does not need a lump sum, but instead requires income from her pension, she can use a combination of tax-free lump sum, and her income tax annual allowance to take up to £15,333 as a tax-free income (based on the 2017/18 tax year). This assumes she does not have other taxable income sources for the tax year. Using this option, Sarah would convert £15,333 from the accumulation stage to the income stage. £3,833 (25% of £15,333) would be paid as a tax-free lump sum. Sarah can then take £11,500 as a taxable income, However, because Sarah has not used her income tax annual allowance, she can take this withdrawal tax-free. Sarah can withdraw up to £15,333 free of income tax.
Once the transaction is complete, Sarah would have £284,667 remaining in the accumulation stage. He pension contributions would have to reduce to £4,000 per year as she has accessed the taxable element of her pension. She has not paid any income tax.
Why might Sarah choose option 4?
Sarah might use option 4 if she does not need a high level of income, and wants to take a tax-free income from her pension using available allowances. Perhaps she has some savings she can also rely on for income, or is using tax-free accounts like ISAs.
Option 5 – traditional drawdown income*
Before flexible pensions Sarah would have been able to take a flexible, taxable income, called capped drawdown. One option under these rules would have been to take tax-free lump sums and taxable income together. There were limits to the withdrawals she could take, which have been removed under flexible pensions rules. This can be replicated using option 5. let’s assume Sarah needs an income of £2,500 per month to live on after tax, and she has no other sources of income. Using the traditional drawdown method, we would need to calculate the amount needed to be paid out, taking into account the income tax on the withdrawal. Sarah could convert £32,586 from the accumulation stage to the income stage. The withdrawal could be made up of 25% of this amount as a tax-free lump sum, which would be £8,146. The remaining £24,440 would be paid out, but subject to income tax. Sarah would pay income tax of £2,586, but would receive £30,000 income after tax.
Once the first year income is complete, Sarah has received £30,000, but her remaining pension has been reduced to £267,414 because of the income tax payable.
Why might Sarah choose option 5?
Sarah might use option 5 if she needs a greater level of income. However, option 6 below, has a more tax-efficient withdrawal method, at least in the early years. Sarah should also plan ahead as her withdrawals might deplete her funds quickly, leaving her with no income in the future.
Option 6 – tax-free flexible income
Flexible pensions allow you to take tax-free pension withdrawals from different parts of your pension plan, at various stages. Therefore, if we assume that Sarah still requires £30,000 income, we can arrange this so that no income tax is paid, at least in the early years of the plan. This could mean that Sarah leaves the maximum amount to grow tax-free in her pension plan, and may extend the lifetime of her money. Sarah would convert £74,001 to the income stage of her pension. This could be divided into 2, so that she takes £18,500 as a tax-free lump sum, plus £11,500 as a taxable income (assuming Sarah has the full income tax annual allowance available to her). The total withdrawal would be £30,000, and would be a tax-free pension withdrawal. Sarah would avoid income tax on this withdrawal, leaving £270,000 in her pension plan to grow tax-free.
After the transaction completes, Sarah would retain £270,000 in her pension, with £225,999 in the accumulation stage, and £44,001 in the income stage. Sarah would not be able to pay in more than £4,000 per year into her pension plan.
Why might Sarah choose option 6?
Sarah might opt for option 6 if she wants to minimise the income tax paid on her withdrawals, especially if she needs to bridge a gap in her income for a few years. Sarah might use this option if she retires early before other pension benefits come into payment.
Tax-free pension withdrawals – general principles
Clearly, flexible pensions, and tax-free pension withdrawals can be a complex set of arrangements. We recommend that you seek financial advice before making any changes to your pensions as withdrawals can have unintended consequences further than the issues covered in this article. You should think about these general principles:
- What is the money for? Do you need a lump sum for a specific need, or income to fund your lifestyle?
- Will you spend it? The default should be to leave your pension fund alone, until you actually need to spend the money. Pensions grow tax-free, so any withdrawals need to be spent, or you risk paying tax on the withdrawal, plus tax on the capital once it is outside your pension plan.
- Other income sources This article ignores the effect of other income sources such as other pensions, property, or savings. Think about how much income you need, when you need it. Perhaps you could use your tax-efficient pension withdrawals to fill in gaps from other income sources.
Planning your own retirement?
I am grateful to Chris Quinn, who pointed out an error in the calculations for Option 5!
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About Dan Woodruff
Certified Financial Planner & Chartered Wealth Manager at Woodruff Financial Planning
Financial Planning helps you to navigate and anticipate significant life changes. I want to help you to ensure your money is managed wisely to give you the financial security that will fund the future and lifestyle that is important to you.