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Home > Blog > Pensions > What Is The Most Tax-Efficient Way To Draw A Pension?
Tax efficiency is crucial when planning to access your pension funds, as every penny saved on taxes can help your pension funds go further. Some of the options for accessing your pension savings include tax-free lump sums, annuities, drawdown and taxable lump sums. But how do you decide what is the most tax-efficient way to draw your pension?
In this article, we will explain the main drawdown options available and their tax implications.
The most popular type of pensions are defined contribution pensions. Defined benefit (or final salary) pensions follow slightly different rules – and we’ll be covering these in a different post.
With defined contribution pensions, you can usually begin to access your pension funds from age 55 onwards (increasing to 57 from 2028, generally). While we don’t recommend rushing to dip into your pension – after all, it has to last the rest of your life – you now have more options than ever for accessing your pension funds, thanks to the pension freedoms introduced in 2015.
The main pension income options available to you include the following, each of which has its advantages and disadvantages and can be combined to give you added flexibility:
Most defined contribution pensions allow for 25% of the fund to be taken tax-free. You can take this as one lump sum, known as a Pension Commencement Lump Sum (PCLS), when you cash in your pension to buy an annuity or withdraw funds through a drawdown scheme (known as “crystallising” your pension).
If you have no plans to purchase an annuity or enter drawdown, you could take several uncrystallised funds pension lump sums (UFPLS), with each smaller deposit having a 25% tax-free portion. With this option, the remainder of your pension pot stays invested.
Not all pension providers offer the latter option, though, so make sure you speak with a pension adviser to ensure your pension plan can facilitate drawdown.. Also, remember that some providers might limit how much you can take out and how often. They may also charge a fee for each transaction. Plus, your investments can go up or down, depending on the market.
Whatever you choose, though, remember that the remaining 75% over and above the tax-free element of your pension will be taxable as income.
When you reach retirement age, one option is to exchange some or all of your pension pot for an annuity, which gives you a guaranteed income. There are various types of annuity products available. The best-known are lifetime annuities, which give you a guaranteed income for the rest of your life, and fixed-term annuities, which give you a guaranteed income over a set period (anywhere between one and 40 years).
Do keep in mind that once you have set up an annuity, you cannot change it – you can’t transfer it or take out a lump sum. So you’ll need to think carefully about choosing the right annuity product for your circumstances, or speak to a qualified expert to find out what’s right for you. Depending on your provider, you may be able to arrange for your income to rise in line with inflation or at an agreed rate.
All income from an annuity is defined as “earned income”. That income is subject to income tax, much like employment earnings are, under HMRC’s pay-as-you-earn (PAYE) system. Of course, the amount of income tax you pay on your annuity income is entirely dependent upon your total income, based on all your income streams. You will then be taxed according to the relevant tax band (more on this later).
When purchasing an annuity, it pays to fully disclose your medical history and family medical history. An annuity provider (insurance provider) uses your expected life expectancy and mortality tables to determine the rate they give you, so if they think your life expectancy is shorter you may be offered a higher rate.
Another option is to take a flexi-access drawdown. You can access your pension fund gradually and receive regular payments while keeping the rest invested. This can be more tax-efficient than a lump sum, allowing you to spread the amount you take over a longer period and potentially take advantage of your changing tax bands. Drawdown also gives you greater flexibility than an annuity, enabling you to vary your payments.
As we mentioned earlier, keeping your pension funds invested has its risks. On the one hand, the longer you invest your money, the better chance it has to grow. But on the other hand, market fluctuations can cause your investments to go down and up, and you may end up with less money than you invested. One strategy to mitigate that risk is purchasing an annuity and taking a drawdown, for the best of both worlds, or another strategy could be to reduce the level of risk you’re taking with your pension, to try and smooth out the market fluctuations.
Once you have taken your 25% tax-free lump sum, you can take the remainder of your pension as one lump sum. This option is not usually advised for larger pensions because the resulting tax bill could wipe out a sizeable chunk of your money.
However, it can be a practical solution for smaller pension pots (£10,000 or less) that you do not intend to consolidate. You can cash in up to three small personal pensions in your lifetime as so-called small pot lump sums.
With all the options mentioned above, it’s really important to seek financial advice from a fully qualified pension professional to ensure you make the best decision for your circumstances.
When accessing your pension funds, it helps to know the applicable allowances, income tax bands and rates.
For example, the current tax-free allowance for all UK taxpayers is £12,570 (frozen until 2028). So any retirement income you take up to that threshold won’t be taxable. However, your taxable income considers all your earnings, including the state pension and any other revenue (eg rental income) – so keep in mind that your combined income may still lead to a tax bill.
This overall income determines your tax band and rate. In England, Wales and Northern Ireland earnings of between £12,570 to £50,270 will continue to be taxed at the 20% basic rate. However, changes to the higher and additional rate tax bands, announced in the recent Spring Budget, come into effect from April 2023. As such, the higher rate 40% tax will apply to earnings from £50,270 to £125,140, bringing additional rate (45%) taxes into play sooner than the previous £150,000 threshold.
The rules are slightly different in Scotland. For the 2023/24 tax year, the tax rates for earnings between £12,571 and £43,662 remain unchanged. Therefore, the 19% Starter Rate still applies to earnings of £12,571 to £14,732, the Scottish Basic Rate of 20% applies to earnings of £14,733 to £25,688, and the Intermediate Rate of 21% continues to apply to earnings of £25,689 to £43,662.
However, earnings above £43,663 are now taxed at the Higher Rate of 42%. Plus, the Top Rate tax threshold has been reduced from £150,000 to £125,140 (mirroring the UK Government’s changes) but with earnings over that threshold now taxed at 47%.
Further changes to pensions announced by the Chancellor include abolishing the £1,073,100 Lifetime Allowance from April 2024 (the Lifetime Allowance tax charge will be removed from April 2023). And the annual allowance is increasing from £40,000 to £60,000. Both announcements make remaining in employment for longer (particularly for higher earners) a more attractive option.
Even those who want or need to access their pension funds but would like to remain in work, perhaps in a part-time capacity to top up their retirement income, will also benefit from an uptick in the Money Purchase Annual Allowance (MPAA), which will enable pension savers to contribute up to £10,000 into their pensions each year (up from £4,000).
As well as tax efficiency, there are various other factors to consider when accessing your pension, including:
When planning for retirement, you should consider your health and longevity, including potential changes to your health over time. None of us has a crystal ball to predict health problems, but ensuring you don’t take out too much money early in retirement can ensure you have enough funds for potential medical or care bills later in life. Several studies have shown that many people underestimate their life expectancy, making careful planning vital.
If you die before age 75, your beneficiaries won’t pay tax on the inherited defined contribution fund. If you die later than that, the inherited pension income will be taxed at your marginal rate. Beneficiaries can typically set up an annuity, take a lump sum, or set up drawdown (depending on the provider) if you die before accessing your pension or when taking drawdown. Unless you set up a joint life annuity, annuity payments stop when you die, and any remaining balance is usually kept by the annuity provider.
As seen in the recent Spring Budget, the pension landscape is constantly evolving – so it’s worth keeping an eye on changes in taxation laws or regulations that may affect your pension income.
Each method of accessing your pension funds has its tax implications, so it’s essential to understand these before making any withdrawals. You should also keep in mind that any other income earned throughout the year may impact the amount of tax you will need to pay. Using an experienced financial advisor will help you make the most tax-efficient decisions when drawing your pension.
Accessing your pension requires careful consideration and planning to make the best choice for you and your loved ones. Hilltop offers a highly personalised advice service with specific guidance on pensions. Our advisers can help you to maximise your income while minimising your tax burden.
For pension advice or to arrange a pension review, please contact us on our website or call us on 0161 413 7051.
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