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How does pension drawdown work?

How does pension drawdown work

How does pension drawdown work?

Does your current scheme allow for Flexi-access drawdown and more importantly how does pension drawdown work? In this blog, we will provide a brief overview of pension drawdown and what you need to know. As always, for in-depth information please feel free to reach out to us with any questions and you can check our previous blogs on pensions. The HMRC introduced new tax rules back in April 2015. It allowed Flexi- access to pensions.  Pension drawdown allows for regular retirement income. Your financial adviser will choose the right funds designed to grow your pot for this purpose.  

From the introduction of Flexi-access drawdown in April 2015, people started to have freedom over their pension pots. The majority of pension schemes tend to offer an annuity upon retirement and most savvy individuals and investors do not want this option. Most people prefer a certain degree of flexibility in order to have a choice of how much to take out and when.

On 6th April 2015, the HMRC published information on pension changes. This prompted pension members to transfer their defined benefit pensions to defined contributions schemes. It enabled them to access the new pension freedom rules.

So how does pension drawdown work?

When a member is of eligible age, under 75, and decides to avail of Flexi-access drawdown, this triggers a benefit crystallisation event. All subsequent payments are taxable as income. The amount of tax you pay will depend on your personal circumstances and depend for example of the amount of payments you receive in a given tax year.

Lump-sum payment (Tax-free lump sum/PCLS):

You will be able to avail of a 25% tax-free lump sum. This is called an ‘uncrystallized funds pension lump sum’ (UFPLS). Once you take out this sum, there is no limit on how much income you can subsequently take out. 

Lifetime Annuity (This is also known as guaranteed income):

If you take a lifetime annuity this will be paid for the duration of your life. You can still take a 25% tax-free lump sum and you will pay tax on your annuity income. We have written more on annuities and you can have a read here. Annuities typically have high fees and the growth might not match the stock market growth. If you change your mind, it is usually very hard to get out of an annuity contract. Members usually decide to get on as it pays out regular payments but with Flexi access drawdown, you can invest in funds that pay regular dividend income.

Capped drawdown:

After 6 April 2015, there are no schemes that offer new capped drawdown.  You might have been in an older scheme before this date which offered capped drawdown. If you transfer to a different scheme you can covert your capped drawdown to Flexi-access drawdown.

Short-term annuity vs income withdrawal:

Short term annuities will be paid at least annually for a period of no more than 5 years. The income withdrawal following after the tax- free pension commencement lump sum is subject to tax. Members can take out as little or as much as they want each year. It is chargeable to income tax as pension income. The scheme administrators deduct the income tax under PAYE regulations.

Withdrawal of your entire pot as cash:

Take the whole amount out in one go. After the 25% tax-free lump sum, the remainder will be taxed at your highest tax rate. There can be many risks with this , so make sure you speak to a qualified independent adviser.

Questions to ask financial advisers

When you decide to transfer your pension from your current scheme to one that allows Flexi-access do some research on advisers.  Make sure that they are independent financial advisers.  They will look at the whole market in order to find the best solution and provider. If you are over the age of 55,  income drawdown is one of several options available, so make sure you talk about all possible solutions.

Below are some other questions so you can ask them. This will help you understand your choices and then you can decide if the adviser is the right fit for your needs.

  • Can you give me a comparison of the benefits and risks of pension drawdown?
  • Can you walk me through the transfer process?
  • Please summarise the advantages and disadvantages of your recommendation?
  • What other options I have?
  • Do you have any customer testimonials or an independent rating of your companies service standards from Trustpilot or Feefo?

Before you choose an adviser, make sure you are comfortable with their fee model and explanations and that it suits your circumstances. If you have never taken out professional financial advice before, getting the right solution for your pension means that the time has come to get advice.

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