Retirement should be a celebration, not a puzzle. With the pension freedoms legislation introduced in April 2015, how you access your pension savings has changed forever. Pension scheme members now have more flexibility; it doesn’t matter if you have a defined benefit pension, a defined contribution pension, or more than one pension pot, but new freedoms mean more responsibility.
Previously most members of the pension scheme were required to buy an annuity with their pension pot, securing a lifetime income with little room for personal circumstances. Today your options are wider, with income drawdown, tax-free sum withdrawals, and even taking your whole pension fund as cash. Understanding the tax implications, advantages, and potential pitfalls of each option is key to maximising your retirement outcomes.
This guide will help you explore your pension choices, from flexi-access drawdown to annuities and cash lump sums. We’ll also cover what these options mean for your tax liabilities, how much tax may be due, and when seeking independent financial advice or speaking to a regulated financial adviser can help you get the best retirement income strategy for your life expectancy, health conditions, and retirement plans.
What are Pension Freedoms?
Pension freedoms refer to the 2015 reforms that gave people with defined contribution pensions (DC savers) much more control over how and when to access their pension pot from as early as state pension age (currently 55, rising to 57 from 2028). You are no longer forced to buy an annuity; instead, you can choose income drawdown, take a tax-free sum, opt for adjustable income, or even take the whole pot as cash.
The main points are:
- Up to 25% of your pension pot can be taken as tax-free cash, with the remainder subject to income tax at your marginal rate.
- The ability to flexibly access your pension, whether by regular income, occasional lump sum, or even taking money from more than one pension at the same time.
- Better benefits for passing retirement savings to beneficiaries, often with tax-free status if you die before 75 and marginal income tax rates thereafter.
For anyone with multiple pensions, these changes are especially significant. Different schemes may have different rules, especially between defined benefit and defined contribution pensions, so understanding your pension provider’s terms or seeking impartial guidance is key.
Option 1: Pension Drawdown
Drawdown is now a core option for many pension scheme members. Instead of converting your whole pot into a guaranteed income, you leave your pension invested and draw a flexible income as needed.
How Drawdown Works
Flexi-access drawdown lets you adapt withdrawals to your needs. Take bigger payments when needed, pause income, or vary how much you take year by year. Drawdown is very attractive if you want control and the potential for investment growth, especially if you have other savings or sources of secure income, such as a defined benefit pension or state pension.
The first 25% you withdraw from your pension pot is tax-free cash; any further withdrawals are added to your other income and subject to income tax. You must plan withdrawals carefully to minimise your tax liabilities and not pay more than you need to.
Benefits of Drawdown
- Maximum flexibility to tailor your retirement income to your personal circumstances.
- Ability to take cash lump sums as needed or leave funds invested for growth.
- The remaining retirement savings can be passed on to your beneficiaries, possibly with untaxed status.
- Drawdown may produce a higher income over time depending on investment performance.
Drawdown Considerations
Drawdown is not risk-free. Your retirement savings are exposed to the stock market, so poor investment periods can reduce the value of your pot and potentially result in less retirement fund. There’s also the risk of outliving your pension fund if you underestimate your life expectancy.
Most members of the pension scheme are encouraged to seek financial advice. A financial adviser or impartial guidance service like Pension Wise can help you work out the right level of adjustable income, how much tax you will owe, and whether drawdown or another pension option is right for you and your health conditions.
Option 2: Buying an Annuity
Despite the changes, an annuity is still the simplest way to guarantee an income for life from your pension pot. This is especially useful if you want a secure income with no risk from the stock market.
Types of Annuities
- Lifetime Annuity: Pays a regular, guaranteed income for the rest of your life.
- Escalating/Inflation-linked Annuities: Payments rise to protect against living costs.
- Enhanced Annuity: Higher income for those with qualifying health conditions or lower life expectancy.
- Fixed-term Annuity: Guaranteed income for a set period (not for life).
Benefits of Annuities
- Guaranteed income, no stock market risk.
- No need to monitor or manage investments.
- Option to provide income for a partner or dependents after your death.
Annuity Considerations
You give up access to your retirement savings once the annuity is bought, with no future cash lump sum, less flexibility, and potentially less if you die early. Your annuity income is taxed (after your 25% tax-free lump sum). Rates vary between providers and depend on your age and health.
Compare annuity options, consider combining with drawdown or keeping other savings for emergencies, and seek independent financial advisory service to get the best outcome.
Option 2: Cash Lump Sums
You can take your whole pension pot as cash if you want. Popular for those with smaller pension pots or other secure income (like a final salary pension or state pension).
Cash
- 25% of each withdrawal is untaxed; the rest is added to your income and taxed.
- Taking your whole pot in one year can mean a higher rate or additional rate of income tax, consider spreading withdrawals over multiple tax years.
- Once fully withdrawn, money loses pension protection against inheritance tax and must be managed to last throughout retirement.
Risks of Cash
- Cash may be tempting, but you risk outliving your funds.
- Funds not in a pension lose growth potential and favourable tax and estate planning treatment.
- Some members may also miss out on valuable defined benefit guarantees by transferring and withdrawing early.
If unsure, seek impartial guidance or regulated financial advice before acting.
Combining Your Options
You don’t have to choose just one. Many members find it effective to combine annuities, drawdowns, and lump sum withdrawals. For example, you might use part of your pension pot to buy a secure income through an annuity for essentials, keep other savings in drawdown, and use the rest for a tax-free lump sum or future emergencies.
Mixing pension products can help you balance flexibility, secure income, and tax efficiency, especially if you have multiple pension plans or a mix of defined benefit and defined contribution pensions.
Your Final Decision
Your retirement income choice depends on:
- Your personal circumstances, including health conditions, family needs, and life expectancy.
- The tax implications of different withdrawal strategies and how much tax you’ll pay on retirement funds.
- Whether you want a secure income or the ability to access your retirement savings flexibly.
- Your attitude to investment risk and the stock market.
- The importance of leaving an inheritance or supporting loved ones after your death.
Your decision should be made with an independent financial advisory service, especially for complex cases like defined benefit transfers or if you’re unsure about the tax implications or pension options. Free, impartial guidance from Pension Wise or advice from a regulated financial adviser authorised by the Financial Conduct Authority can be very helpful.
Make the Most of Your Pension Freedoms
Pension freedoms mean retirement income is no longer one size fits all. Whether you’re taking a tax-free lump sum, opting for drawdown, buying an annuity, or combining strategies, your pension pot can support your lifestyle if you plan carefully, consider tax, and review your pension provider’s offers.
Take time to review your retirement age, pension plans, regular income needs, and the benefits of seeking professional advice. Remember, scheme members today have more choice and flexibility than ever before, but making the right choice means understanding your retirement savings, retirement plans, and tax implications.
Get expert independent financial advice today.
Take control of your retirement. Compare your pension freedom options, and choose the best for you, whether you want a guaranteed income, flexibility to access your funds, or to pass on your pension savings to loved ones.