What is Income Drawdown?
This a special type of personal pension plan which you can transfer to after the age of 55 and after taking your 25% tax free cash you can take income payments (which are taxed at your marginal rate) direct from your pension pot.
In many ways, this is similar to taking an income direct from your bank or savings account (with some extra rules) and if you take more income than the interest or investment growth the value of your pension pot will reduce and at the extreme you could run the pot dry.
With pension drawdown you can take regular or ad hoc income payments directly from your pension pot. This means you keep control over your pension pot and have the flexibility to spend and invest your pension pot as you want.
It is important to remember, unlike an annuity, your income is not normally guaranteed and if you take too much income in the early years or if the fund does not increase in value as planned, you could end up with a lower income or even run out of money entirely.
There are no minimum or maximum income limits which means that up to 100% of the fund can be taken as an income payment and income payments can normally be taken at any time.
In practice, most people will either make regular income withdrawals to provide retirement income or a take series of ad hoc income payments to supplement their other retirement income in a tax efficient manner.
All income payments will be taxed at the recipient’s marginal rate of tax. Higher rate tax payers may be able to reduce their tax planning by spreading or phasing income payments if they will be basic rate tax payers in future years.
Your pension pot can be invested in a number of ways ranging from cash, bonds, equities and even property (you cannot invest directly in residential property).
A drawdown pension plan can be invested in a wide range of things including:
- Cash accounts with banks and building societies
- Pension funds from insurance companies
- Unit trusts and onshore and offshore open ended investment companies (OEICs)
- Investment trusts
- Individual stocks and shares quoted on a recognised UK or overseas stock exchange Commercial property
It is very important to get the investment strategy right because the success or failure of a drawdown plan depends on the future investment returns. Invest wisely and you should be better off than by purchasing an annuity which provides guaranteed income but no flexibility. However, if you invest unwisely you may end up worse off than by purchasing an annuity and at worse you could run out of money.
You can leave money to your family
After your death, any money remaining in your pension pot can be left to your beneficiaries.
Most drawdown plans offer three options following the death of the plan holder:
- Pay the balance of the drawdown pot as a cash lump sum
- Arrange flexi-access drawdown for beneficiaries (no income needs to be taken)
- Purchase an annuity for selected beneficiaries, normally a spouse / partner
If the plan holder dies before age 75, all payments (cash or income) will be tax free, but if death occurs after age 75, any cash or income will be taxed at the marginal rate of tax payable by the beneficiary.
There are three types of beneficiary; a dependant, a nominee and a successor. A dependant is a spouse, civil partner, child under the age of 23 or someone who was financially dependent on the plan holder. A nominee is anyone nominated by the member and a successor is anyone nominated by one of the beneficiaries. In short, almost anybody can be nominated to be a beneficiary of a pension pot.
Although many people may choose to nominate their spouse or partner as a beneficiary, it is possible to nominate children or other family members or friends as beneficiaries and so the pension fund can be handed from one generation to another.
Watch out for
There is a lot to watch out for but by far the two most important things to keep an eagle eye on are:
- The amount of income you take out – if you take too much income you could run out of income in later life
- Where your drawdown is invested – if you take undue risk you could end up with a much smaller pension pot
These two things are intricately linked because of the sequence of return risks. Investing when you are taking income withdrawals is different to investing without taking income and this is because if the returns are low or negative in the early years you will erode your capital fast and it will be hard to recover from early losses.
When you take income from a flexi-access drawdown it will be a trigger event for the Money Purchase Annual Allowance (MPAA).
Although drawdown may seem easy to understand the risks are much harder to understand, especially if compared to the guaranteed income from an annuity.
Better Retirement have over 25 years’ experience of advising clients about annuities and pension drawdown and we will be pleased to provide you with more information or advice.