How income drawdown works

In this section we will cover:

• The advantages and disadvantages of income drawdown
• How tax affects drawdown
• The pros and cons of getting an annuity

What is drawdown?

Income drawdown allows you to keep your pension invested after you start taking money from your pension. You ‘draw down’ money from your pension pot to use when you need it. The rest is left invested in the hope that it continues to grow. 

Whether income drawdown is a good idea for you will depend on your circumstances, health and attitude to risk. Drawdown gives you a more flexible income: you can take different amounts of money at different times, depending on when you need it. 

You can choose to put your pension into drawdown initially and buy an annuity later with some or all of your remaining pension. You can also buy an annuity with some of your pension and leave the rest invested. The options available to a customer are dependent on their pension provider.

The advantages of drawdown:

• You can take the money when you want to, in differing amounts as required. This can be more tax efficient and allows for changing needs in retirement. 
• The unused portion of your money can remain invested while you are not using it, giving it the chance to potentially grow in value and offset the eroding effects of inflation.
• You can continue to pay into your pension as long as the pension provider allows this, though this is subject to the Money Purchase Annual Allowance (MPAA).

The disadvantages of drawdown

• There is a lack of certainty. Nobody knows how long their retirement will last, and if you live longer than expected or have expensive care bills, you could run out of money. 
• If your money remains invested, the value of your pot could fall if markets drop, and this may reduce the income you can take, and this could affect your retirement income. 
• Your investments will require regular monitoring and reviews to ensure you remain on track to meet your financial goals. You simply cannot set them aside and forget about them.

Are there any tax implications of income drawdown?  

You can usually take up to 25% of your pension tax-free, subject to the lump sum allowance which at the time of writing is £268,275. The rest is taxed at your ‘marginal’ rate of income tax when you withdraw.  

Your marginal tax rate is the rate you pay on the last pound of income you earn, so you will pay more tax on some of your pension if you are earning other income at the same time, or if you take it all out at once and go over the tax threshold for paying basic rate tax. 

It is often best to structure withdrawals so that you do not pay too much tax. Your options may include: 

• Taking this 25% tax free lump sum in smaller amounts throughout your retirement to help reduce tax liabilities. 
• Using other savings – e.g. ISAs (Individual Savings Accounts) – as well as your pension at various points. 

How many times can I withdraw from my pension? 

How often you withdraw from your pension is up to you. You can take the money how and when you like, depending on your pension provider and whether they support certain payment frequencies – but should bear in mind your tax liabilities when you do so, as well as how much is left in the pot for the rest of your retirement. 

Taking smaller lump sums from your pension

You could choose to leave your pension pot where it is, to continue to grow tax-free, and to take out small lump sums as and when you need. For each withdrawal, the first 25% is tax-free subject to the lump sum allowance and the remainder would be taxed at your marginal income tax rate. In the industry, this is known as uncrystallised funds pension lump sums (UFPLS).

Taking the whole pension as cash

Depending on the type of pension you have, you might be able to take your whole pension pot as a lump sum. Generally for a defined contribution (DC) pension, the first 25% will be tax free and the remaining amount will be taxed according to your income band and tax rate. It’s important to know that if you decide on this option you could end up paying a lot of tax and could potentially, depending on what you do with the money, not have a regular income for later in life.

What is an annuity?

You might want the predictable income provided by annuities, either as an accompanying source of income to drawdown, or as an outright replacement. Annuities and drawdown get the same tax treatment. So, whether you choose drawdown or to buy an annuity, you can usually withdraw up to a 25% sum from your pension tax free subject to the lump sum allowance, and withdrawals after this will be taxed at your marginal rate of income tax. 

The advantages of annuities

• You know exactly how much you will receive, helping you to plan for retirement.
• You do not have to worry about stock market fluctuations. 
• For certain types of people, including those in poor health, an enhanced annuity can represent good value for money because it could offer higher regular payments because of your state of health.  
• It is usually paid for the rest of your life which means you do not have to worry about your pension running out.
• You can customise your annuity up front by adding spouse's pension, guarantee period, inflation protection and fixed term options.

The disadvantages of annuities

• Unless you buy a more expensive inflation-linked annuity, you could find that your income erodes in value over time. 
• Unless you pay more to buy a joint-life annuity, there will not be money to provide for a partner if you die first. 

J.P. Morgan Personal Investing provides personal pensions with the option of flexible access drawdown at retirement, but it does not provide annuities.

Risk warning

As with all investing, your capital is at risk. The value of your portfolio can go down or up and you may get back less than you invest. Pension eligibility rules apply. Seek financial advice if you're unsure if a pension is right for you. Tax rules vary by individual status and may change. This is general information, not personalised tax advice.