How you can take tax-efficient pension income with drawdown

How you can take tax-efficient pension income with drawdown

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    Even in retirement, there is no escaping the taxman, and you must pay tax on pension income that exceeds your personal allowance. However, an understanding of the tax rules around pension drawdown can result in valuable tax savings.

    Pension drawdown allows you to take as much or little income as you like from your pension. Usually 25% of the pension is tax free, with the remainder classed as taxable income. You can also withdraw up to £12,570 tax-free each year from your taxable pension fund which s within your personal allowance. When you combine the two incomes, it can significantly reduce your tax bill.

    Do you want to pay less tax on your pension drawdown withdrawals? Who doesn’t? In this article, we will delve into the intricacies of flexi-access drawdown. We’ll provide real-world examples and break down pension drawdown tax rules to show you how to take your pension savings in the most tax-efficient way.

    For personalised pension advice, contact Heritage Financial Planning.

    Understanding the basics of pension taxation

    When it comes to pension drawdown, you probably already know that 25% of your pension is tax-free. The remaining pension fund is said to be ‘crystallised’, which means any income taken will be subject to income tax at your marginal rate.

    In other words, if you were a Basic Rate taxpayer and your earnings were below £50,270, and you take funds from your crystallised pension, you pay income tax at 20%. If the pension withdrawal pushed you into the higher tax band, i.e. over £50,270, the surplus amount is subject to income tax at 40%.

    Income tax levels in England, Wales and Northern Ireland

    Let’s take a look at different pension drawdown scenarios.

    How to take a ‘tax efficient’ pension drawdown

    Under current tax rules, it is possible to take a combination of your tax-free pension cash and taxable pension to reduce your tax liability. It may even provide you with a tax-free monthly income from your pension.

    It allows you to stipulate exactly how much tax-free cash and taxable income you want to take. This offers maximum tax efficiency and makes the best use of your personal allowance each year, which is currently £12,570.

    Example:

    • Terrence retires at age 63.
    • His private pension pot is valued at £200,000.
    • 25% of this pot can be taken tax-free as a lump sum or in smaller amounts when needed.
    • He requires a retirement income of £24,000 per year until he is eligible for his state pension at age 66. He has no other income.
    • He will not receive his state pension until age 66, so he has his remaining personal allowance available.

    Terrence can withdraw £12,570 from his taxable savings tax-free.

    He can also take £11,430 from the tax-free portion of his pension pot to make up his required £24,000 income. By doing this, he is able to take £24,000 of his pension tax-free!

    If Terrence had simply taken £24,000 from the tax-free portion of his pension fund, he would have ‘wasted’ the personal allowance, which would have cost him £2,514 (assuming the personal allowance is taxed at the Basic Rate of 20%).

    This option is particularly useful if you retire before the state pension age and have no other income. Terrence can repeat this each tax year until he receives his state pension. He can simply reduce the amount of income he needs from pension drawdown, which will help the sustainability of the pension pot.  

    How to take your Pension Commencement Lump Sum in a tax efficient way

    Upon reaching retirement, if you take some or all of your tax-free lump sum, this is known as a Pension Commencement Lump Sum. We’ll call this a ‘tax-free cash withdrawal’ moving forward.  

    As Independent Financial Advisers, one thing we often hear from clients approaching retirement is that they want to take all of their tax-free cash at once, even if they have no specific purpose and just want to stick it in the bank. They think that if they only take a part of their tax-free cash, they will lose the rest.

    This couldn’t be more wrong. It’s actually possible to take a series of smaller tax-free lump sums or even a monthly regular income made up entirely of your tax free cash. Remember, 0% income tax is due on this drawdown income.

    Example:

    • John has retired and has uncrystallised pension savings worth £100,000.
    • He needs £4k per year to cover his expenditure and has turned to his private pension.
    • He is in receipt of a Defined Benefit pension, and the guaranteed income makes him a Basic Rate taxpayer.
    • This means that he must pay income tax on any income withdrawals from his ‘crystallised’ pension fund.

    However, John can take a monthly tax-free cash withdrawal of £333 (£4k a year) to meet this shortfall. He will not be able to do this indefinitely, as he will eventually use up all of his 25% tax free cash. If we assume there is no investment growth, this will be in approximately 6 years.

    There are two benefits of this tax-free cash withdrawal. It is not just an arbitrary 25% tax-free cash amount of the starting pension. If his uncrystallised funds increase with future investment growth, then so will the amount of tax-free cash in monetary terms.

    Secondly, we all have a tax-free personal allowance which is currently set at £12,570. If this allowance increases by the time John comes to take taxable withdrawals from his pension, then more of his income would be free from income tax. However, it is worth noting that the personal allowance has been frozen until at least 2025.

    Uncrystallised Fund Pension Lump Sums

    Another way you can make a tax-efficient withdrawal from your pension is via an Uncrystallised Fund Pension Lump Sum, or UFPLS for short.

    With an UFPLS, 25% of the withdrawal is tax-free. The remaining 75% is subject to income tax. Breaking this down, if you take a £10,000 withdrawal as an UFPLS, then £2,500 is tax-free, and the remaining £7,500 is classed as taxable income. You can take a monthly UFPLS from your pension to create a tax-efficient withdrawal. 

    Let’s look at a case study where an UFPLS can eradicate or reduce your potential income tax bill as much as possible. 

    • John is retired, and his income is made up of his state pension and DB pension. His yearly income is £15,000 pa.
    • His expenses are £25,000 pa, which means he has a shortfall of £10,000 to meet from his private pension.
    • His pension savings are valued at £200,000.

    If John takes an UFPLS payment of £10,000, then £2,500 will be tax-free, and the remaining £7,500 will be subject to income tax at 20%. This means the tax payable will be £1,500. This is an effective tax rate of 15%. With an UFPLS, John would have saved £500.

    Contact Heritage Financial Planning for pension withdrawal advice

    Strategic planning and awareness of pension drawdown tax rules can empower you to minimise the tax you pay on your pension income. The expert financial advisors at Heritage Financial Planning can help you devise a personalised strategy for a financially secure retirement.

    Don’t miss out on potential tax savings – reach out now and start optimising your pension drawdown and work towards your financial freedom, get in touch with us today.

    Frequently asked questions about tax-efficient pension income

    Do I have to take my tax-free lump sum in one go?

    No. It is possible to take the tax-free portion of your pension fund in one go or as a series of tax-free lump sums. You can choose to take it as a regular income, if you wish, or combine it with withdrawals from the taxable part of your income, of which £12,570 per tax year is available tax-free.

    What is the lifetime allowance?

    The Lifetime Allowance (LTA) is a cap set on the total value of a pension throughout an individual’s lifetime without incurring additional tax charges. As of April 2023, the LTA is £1,073,100.

    What is the money purchase annual allowance?

    The Money Purchase Annual Allowance (MPAA) is a limit set on pension contributions after you have used flexi-drawdown. It is set at £10,000 as of April 2023.

    Do all pension schemes offer drawdown?

    No, not all pension schemes offer pension drawdown. Defined Contribution pension schemes commonly offer pension drawdown as an option. These schemes build up a pension pot based on contributions and investment returns.

    However, Defined Benefit pension schemes, which promise a specific income based on factors like salary and years of service, usually do not offer pension drawdown as a feature.

    It’s important that you review the terms and conditions of your pension scheme to see if pension drawdown is available and if it aligns with your retirement plans. Consulting with a financial advisor can provide further clarity on the options available.

    HM Revenue and Customs practice and the law relating to taxation are complex and subject to individual circumstances and changes which cannot be foreseen. The Financial Conduct Authority does not regulate tax planning

    Alex Norman-Jones​

    Alex Norman-Jones​

    I am one of the founders of Heritage and I am highly motivated to deliver bespoke financial planning solutions to my clients.

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