The abolition of the requirement to buy annuities at retirement means that many people are opting to leave their pension pot invested and draw down an income direct from their fund to supplement their state pension instead.
Apart from withdrawing your 25% tax-free lump sum, it makes sense to leave your money in a pension wrapper where it is virtually free of tax. If you withdraw the balance of your pension pot immediately, you will have to pay income tax on it. If you have a large pension fund it could push you into a higher rate tax bracket. You will then have to find another suitable investment where your returns are also likely to be subject to tax.
You can use drawdown in a variety of ways. You can take out regular withdrawals on, say, a monthly, quarterly or annual basis, or you can withdraw lump sums. Tax is deducted by your drawdown provider before payments are made.
When you take regular withdrawals you will often have the choice of taking:
- The ‘natural income’ – that is the income paid out on the underlying investments, such as dividends from shares, or the interest from corporate bonds. This type of income may fluctuate, although it has the potential to rise over time if you choose the right investments.
- A fixed percentage – you could make fixed withdrawals of say 5% which could be taken from a combination of income and capital. The problem with this approach is that if your withdrawals exceed the growth in your fund, then your capital will gradually erode. If investment returns are poor, you may need to reduce your withdrawals.
- Lump sums – if you have enough regular income from other sources you could take out lump sums as and when you need them.
Another option if you do not want to take the whole of your tax-free lump at once, and you do not need a regular income is to take Uncrystallised Funds Pension Lump Sums (UFPLS) from your pension. With this strategy, each time you make a capital withdrawal, 25% will normally be tax-free and the rest taxed as income. The tax will be deducted at source by your pension provider. There are no limits on how much you can take in the form of a UFPLS but you need to be aware that you could end up running out of money.
If you are thinking of drawing down your pension after you reach retirement it is also worth considering seeking professional independent financial advice. You will have to pay for advice but at this stage of your life, it could be one of the best investments you could make.