In this article, we’re going to talk about some of the options available to you when deciding how to take your pension money.
There are no easy decisions here, and the pension landscape is complex and constantly changing.
We therefore ask that you take this article as a guide to help you process your thinking. Do not treat this as financial advice – rather, speak to an independent financial adviser first prior to making any decisions.
With that out of the way, let’s look at the first question you need to answer:
What kind of pension(s) do you have?
#1 Final Salary Pension
These are an increasingly rare and dying breed of pension. If you have one (sometimes also called a “defined benefit pension”), then your employer will have set this up a while back in your employment.
The idea here is that you receive an agreed annual salary upon your retirement. This is usually based on criteria such as your years in employment, your accrual rate, and your average earnings.
#2 Cash pot pension
This isn’t really an official term. It’s more of a “catch all” phrase to encompass pensions which involve building up a pot of money over time. Another name for it might be “money purchase” pensions.
Different kinds of pension fit into this category. Workplace pensions, for instance, involve both you and your employer contributing to your pension pot. These pensions can take different forms, such as Self Invested Personal Pensions (SIPPs) and stakeholder pensions.
Sometimes these pensions are called “defined contribution pensions”, and this is the type that we will be concentrating on here in this article.
What You Can Do With Your Pension
From this point, we will be dealing with money pot pensions. If you have a final salary pension, we encourage you to read along, as there will information useful to you here as well.
The easy bit is this: from the age of 55, you can withdraw up to 25% of the value of your pension pot, tax free and as a lump sum. The remaining 75% is subject to tax.
We’re not going to talk so much about what to do with the 25% lump sum. Rather, we’re going to focus on the 75% (although, what you do with the latter may inform what you do with the former).
So, what are your options regarding the 75% which is liable to tax?
#1 Take everything in one go
This is the most simple route to get your head around. Simply withdraw all the money at once!
The initial 25% will be tax free, and the rest will be subject to income tax. If you’re thinking about this route, therefore, consider that it could put you in a higher tax bracket.
Remember, you have a personal tax allowance of £11,850 in 2018-2019. Above that, you pay 20% on income up to £46,350. After that, it’s 40% at the Higher Rate until you hit the Additional Rate at £150,000 (which is set at 45%).
Who might this be appropriate for? Possibly for those with very small pension pots (e.g. £25,000), and who also perhaps have urgent debts which need paying off.
#2 Keep everything where it is
It might well be that you do not want to take anything out of your pension. If you do this, then a range of investment opportunities can become available to you.
For instance, you can put in up to £40,000 per year into your pension if it all stays there. (If you withdraw from your pension, you can only put in up to £10,000 a year).
Who might consider this as a plausible option? Those over 55 who do not need to access the money in their pension yet. For instance, many over-55s continue to work for several more years, and can live quite comfortably within their existing income. You might well need your pension money later, however.
#3 Choose a “drawdown option”
With this route, you take up the option to withdraw 25% of your pension pot (tax free).
The rest of your money is then put towards buying an “income drawdown” product. This product is essentially a set of investment funds. The investment returns from the funds provide you with an income in retirement.
With income drawdown, be aware that your income will fluctuate – depending on how well your investment funds perform. If they do well, you will get more. If they perform badly, you will get less.
Who might choose this as a viable option? Those who want both income and flexibility in retirement could benefit from this course of action.
#4 Buy an annuity
This route is very similar to option 3, above. You take advantage of the 25% tax-free lump sum withdrawal. Where it differs is you use the remaining 75% to buy an annuity, instead of an income drawdown product.
An annuity is a financial product which gives you a set income each year, until your passing. When you die, your pension money is effectively gone.
This is different from income drawdown, where your income can vary quite a bit according to your funds’ performance. An annuity gives you a more stable, predictable income in later life.
Who might consider this option? If your main goal is financial security and predictability in retirement, then this course can be an attractive one.
Bear in mind that you tend to receive less income than you would under an income drawdown product. You also cannot usually pass on your pension money as an inheritance. The advantage, however, is that you will always have an income – even if you live a very long time.
#5 Take periodic lump sums
You do not have to take advantage of the 25% tax-free lump sum all at once. You could spread things out.
With this option, you leave your money in your pension pot. However, when you do take money out, 25% of it will be tax-free. The rest of the withdrawal (75%) will be subject to tax.
For example, suppose you take £20,000 out of your pension. A quarter of it is tax free – i.e. £5000. The remaining £15000 is subject to tax.
Who might want to pursue this course? If taking a large sum of money all at once is not important to you, then you should consider it. If flexibility is most important to you, then this could be a good option.