What is income drawdown and could it work for me?

Income drawdown is a popular option when people take their pension. In this article, we discuss what income drawdown is, how it works and the different types of drawdown available.

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Nigel Hatt
Published: 26 Jan 2022 Updated: 21 Jun 2022

What is income drawdown?

Income drawdown is an umbrella term that encompasses all the different types of drawdown, including capped drawdown, flexi-access drawdown, phased drawdown and tax-free drawdown. While it has become a popular option for taking retirement income since the introduction of Pension Freedoms in 2015, income drawdown is not new. It was first introduced in 1995 for the purpose of preventing people from locking themselves into very poor annuity rates.

Going into income drawdown allows you to draw an income from your pension and leave the rest invested, with the aim that it will continue benefiting from investment growth. The idea is that you will draw out an income that is equal to the amount of investment growth on your pension fund. Ideally, you will end up with the same amount of money in your pension that you had at the outset. Not seeing your capital fall in value is the desirable outcome with income drawdown plans.

It is, however, important to bear in mind that while this is the desired result, it isn’t always the reality. As with any type of investment, the value may fall as well as rise, so you could end up with less than you originally invested.

What are the benefits of income drawdown?

The main advantage of going into income drawdown is that your pension savings are not impacted by poor annuity rates and instead they could benefit from investment growth.

As drawdown allows you to take an income directly from your pension, you have the freedom to choose how much income to take and when to take it. This means that you can:

  • Increase or decrease your income in line with any changes to your lifestyle
  • Plan your withdrawals around your other sources of income
  • Carefully manage your income tax bill

Who could income drawdown be beneficial for?

Essentially, income drawdown could work well for people who do not want to buy an annuity. Drawdown is extremely flexible but it is not without its risks. The amount of income you will receive is not guaranteed because it is wholly dependent on investment performance, so it will only work for people who have enough guaranteed income from other sources (i.e. non-pension savings and investments) to meet their basic needs.

Generally speaking, income drawdown could be a good option for people with a large pension pot and a reasonably high tolerance for investment risk as there could be a depreciation in the value of your original investment.

When you’re in income drawdown, seeking professional advice is essential and, in some cases, a legal requirement. This is to make sure that you do not take more money than you need to and that your investment suitability is regularly reviewed.

What are the different types of income drawdown?

There are a number of different types of income drawdown, each with their own set of advantages and limitations.

Capped drawdown

Capped drawdown is a form of income withdrawal. The maximum income that can be taken in a pension year (which starts when you first go into drawdown) is calculated by the Government Actuary’s Department. Any income taken cannot exceed this limit but the amount can be varied from year to year. If the maximum income is not taken in a pension year, the difference cannot be taken at a later date. If you exceed the capped drawdown limit, you will trigger flexi-access drawdown. You will not be able to go back into capped drawdown. You can convert from capped to flexi-access drawdown at any point, even if you have not exceeded your income limit.

Capped drawdown has the advantage of imposing a limit on the amount of income you withdraw, meaning that you significantly reduce the chances of running out of money in your retirement. It’s a legal requirement that these income limits are reviewed by a professional adviser every three years until you reach the age of 75 and then every year thereafter.

It can also be beneficial for people who want to take advantage of the standard annual allowance, because if you are in capped drawdown and you’ve taken the full amount of tax-free cash from your pension, provided that you do not exceed the capped drawdown limit, you will keep your annual allowance of £40,000. In order to continue in capped drawdown, you would have needed to have chosen capped drawdown before 6 April 2015.

Flexi-access drawdown

Flexi-access drawdown allows you to withdraw as much income as you wish. Unlike capped drawdown, there are no limits set. Those people in flexi-access drawdown can take as much or as little as they want from their pension pot when they want it. This means that you can construct your retirement income to suit your own individual circumstances.

Unlike with capped drawdown, regular reviews are not a requirement when you’re in flexi-access drawdown, although they are advisable. As there are no limits to what you can withdraw as income, with flexi-access drawdown there is the possibility that you could run out of money without careful consideration and planning. A financial planner can work with you to create a full financial plan where your future finances are forecasted so you can clearly see how much money you have now and what you’ll need in the future. The amount of income you decide to take will form a part of your plan.

Phased drawdown

Phased drawdown enables you to crystallise your pension fund in stages, consisting of tax-free cash and income. You can take a tax-free lump sum of 25% of the amount you withdraw, with the remaining 75% moved into drawdown to provide you with an income. This approach enables the minimum amount to be crystallised each year to provide the required income level, leaving the remainder of the fund untouched.

Phased drawdown is a good option for people who want to limit the amount of money they take from their pension fund because they are continuing to work, even if it is on a part-time basis, and they need a pension income to bridge the gap in their reduced income level. It is also very useful for people who don’t want to take too much out of their pension as they have other assets, savings and investments that they can mostly live off.

Phased drawdown is extremely tax-effective because you can choose to crystallise only a very small part of your pension fund. For example, you have a pension worth £100,000. You could crystallise £5,000 and take £1,250 as tax-free cash and £3,750 would go into drawdown. The main benefit of this is that you could end up paying no tax on your drawdown pension of £3,750 as it may be within your personal allowance of £12,570. Phased drawdown offers a way of managing your tax situation as well as leaving the maximum amount of your pension untouched.

Tax-free drawdown

Tax-free drawdown is a form of drawdown that comprises a tax-free lump sum and a tax-free income. It is not used that often but it could be useful for people who previously had a defined benefit pension (also known as a final salary scheme) and transferred it to a money purchase scheme.

For example, you need an income of £14,000 from your pension fund to supplement your final salary pension of £8,500 a year. You could crystallise £40,000 and take £10,000 as a tax-free lump sum and £4,000 as an income. You could end up paying no income tax on this because your total pension income would be £12,500 which is within the personal allowance of £12,570.

What’s the difference between income drawdown and lump sum withdrawals?

When you go into income drawdown, you will receive an income which consists of a tax-free cash sum and a pension. If you take a lump sum withdrawal, you will receive a tax-free cash sum but no pension. The latter might be an option to consider if you needed some capital to fund some home improvements or a holiday, for example.

What happens to my drawdown pension when I die?

When someone who is in income drawdown dies, beneficiary drawdown is normally offered by pension providers. This enables the inherited monies to continue to grow in a tax-privileged environment.

The pension of the person who has died is simply transferred into the name of the beneficiary and the funds do not leave the pension wrapper. If the death occurs before age 75, there is no inheritance tax or income tax payable on the withdrawals. If the death happens after age 75, income tax becomes payable at the beneficiary’s marginal rate if they actually draw any income but there is still no inheritance tax to pay.

If the beneficiary takes a drawdown income from the pension, they will not trigger the money purchase annual allowance. This only happens if you take drawdown income from a pension in your own right, not inherited funds.

Talk to Evelyn Partners

If you want to know more about income drawdown and how it could work for you, talk to Evelyn Partners. Book a no-obligation consultation online or call us on 020 7189 2400.

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Disclaimer

This article was previously published on Tilney prior to the launch of Evelyn Partners.