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Cash and drawdown income options

There are no income limits on a flexi-access drawdown pension. Individuals in drawdown can take as much as or as little income as they need. Any funds not drawn remain invested in a tax advantaged environment, with no UK tax on income or capital gains, and are outside the estate for IHT.

This income flexibility provides an opportunity to manage drawdown so it can be taken in the most tax efficient way. For example, withdrawals could be:

• all income - which is fully taxable
• just tax-free cash - with no tax payable, or
• a mixture of both taxable income and tax free cash - so that only part of the withdrawal is taxable

However, income flexibility can also mean those who withdraw everything in one go face a large tax bill.

Tax-free cash

Up to 25% of the pension fund can normally be taken as tax-free cash, subject to the individual’s remaining lump sum allowance – the standard allowance for those without transitional protections is £268,275.

It's not all or nothing when taking tax-free cash. Benefits can be phased into drawdown, with tax-free cash available each time new funds are crystallised. The right to tax-free cash from those crystallised funds is lost if an individual chooses not to take tax-free cash when they crystallise the benefits.

Phasing benefits can allow tax-free cash to be used to supplement income, with payments made up of a mixture of cash and taxable income.

Of course, it's possible to just take tax-free cash to meet income needs. This strategy could be used in the early years until all the tax-free cash entitlement has been exhausted. But it's important to consider not just what results in the least amount of tax today, but the impact on tax due in the future.

Once all the tax-free cash has been taken, all future withdrawals will be taxable income which could mean more tax in the long term - particularly if future income is pushed into a higher tax band. It may make sense to withdraw both taxable income and tax-free cash to meet retirement needs, making use of basic rate bands each year if this is likely to result in a lower amount of tax paid overall. The individual's age and health will be a dominant factor in this strategy, together with any non-pensions savings they have accumulated.

Unlike UFPLS, tax-free cash from drawdown is not limited to 25% if an individual has protected cash over this amount. For example, someone with scheme-specific tax-free cash protection will normally still be able to take the protected amount above the standard 25%. However, the protection will be lost unless all benefits under the scheme are crystallised at the same time - so it's lost if the client uses a phased retirement strategy within the scheme. Of course, where drawdown is used, there's no requirement to take any income when the benefits are crystallised. See our guide ’Scheme-specific tax-free cash’ for more details.

Drawdown income

Income paid out under drawdown is taxed as pension income under PAYE in the year of payment. This could be at 20%, 40% or 45%, depending on the individual's total income. Should income fall within the personal allowance, there may be no tax to pay at all. Other rates may apply in Scotland.

Some individuals will have significant savings which gives them more flexibility in what they do with specific pension pots. They may not even need it at all, preferring to leave their pension savings as an inheritance for their beneficiaries who could pay less tax, or possibly even no tax at all.

Many savers will rely on their drawdown pot to provide an income for the rest of their lives. The key to sustainability is only drawing what's needed, carrying out regular income and investment reviews and using the tax allowances and tax bands available to ensure that they don't pay more tax than they need to.

Initial income payment - emergency tax codes

Care is needed when initially going into drawdown as the first payment will often be taxed using an emergency tax code on a month one basis. This doesn't take into account any previous payments in the current tax year. It simply applies 1/12th of the personal allowance, basic rate and higher rate tax bands against the payment, with anything above this attracting additional rate tax. (Please note that different tax rates and bands may apply to Scottish taxpayers).

The emergency tax code for 2024/25 is 1257L. This will give a tax free amount on the first payment of £1,047.50 and the rest of the payment will be taxable.

This normally results in an overpayment of tax, which can come as a surprise to individuals, particularly if they need a certain amount for a particular purpose. It might be possible to have any overpayment of tax corrected by the issue of a new tax code by HMRC, which will apply to any subsequent payments. However, this option depends upon the size of the overpayment and when in the tax year it occurs.

If no subsequent payments are planned, the overpayment of tax can be reclaimed. HMRC have issued specific forms for this purpose, depending on the individual's circumstances.

For those wishing to withdraw their whole fund, this can be achieved by completing either:

• form P50Z - for those who have no other PAYE or pension income (other than State Pension), or
• form P53Z - for those who have other employments or pensions

For individuals who are planning to make a single withdrawal or irregular withdrawals that don't empty their pension pot, or who don't intend to take a further payment in the same tax year from the same scheme, form P55 can be completed.

Triggering the money purchase annual allowance (MPAA)

Drawing more than just tax-free cash will trigger the MPAA which means that the maximum that can be paid to defined contribution plans without facing a tax charge reduces to £10,000 a year, with no carry forward available.

This could create an issue for those still saving into pensions (including an employer funding) and could also reduce tax planning opportunities.

A mix of income and tax-free cash

Drawdown allows withdrawals to be taken which are part taxable income and part tax-free cash. Such withdrawals will typically consist of 75% taxable income and 25% tax-free cash.

However, some providers may allow income withdrawals to be taken in different proportions. It's possible for a withdrawal to be made up of a higher proportion of tax free cash (provided there are sufficient uncrystallised funds available) but this would mean crystallising more of the funds. The crystallised element not taken would stay in the pension as crystallised funds and would be taxable when taken at a later date.

Spreading tax-free cash across retirement to supplement income can lead to lower overall tax in retirement.

This simple example assumes no investment growth and tax allowances/bands remain at 2024/25 levels. There are number of factors (time frame for withdrawals, income levels, tax rates and other assets available etc.) which will determine which option provides the most tax efficient withdrawal strategy. Clearly if Simon had poor life expectancy it may have been beneficial take the withdrawals needed from tax-free cash first.

Taking everything in one go

Taking a pension pot all in one go may be tempting for pension savers. However, it means all the retirement income is squeezed into a single tax year with only one year's tax allowances and bands available. The result is more income could be taxed at higher rates than the saver would normally expect to pay.

This basic example demonstrates the tax savings that could be made by spreading payments over a few years rather than just in one go. The bigger the pension pot, the bigger the potential tax saving.

Use of tax allowances and bands

The flexibility of drawdown means individuals can make the most of their tax allowances.

For those with larger pension pots and higher income needs, drawdown can be used to keep income below important tax thresholds such as the higher rate tax band or keeping income below £100,000 to maintain the personal allowance.

Combining drawdown with other savings

The ability to switch off drawdown income can be an effective tax planning tool. Taking little, or no, drawdown income can allow profits from other savings to be taken tax efficiently.

This approach could also be beneficial for IHT too. For those with large estates, it can make sense to draw on non-pension assets first because pensions are normally outside the estate for IHT.

This strategy means that tax privileged savings are retained for the longest period and can result in a larger inheritance for beneficiaries.

Investment bonds

Gains from investment bonds are subject to income tax. Reducing the amount of drawdown income taken in the tax year of a chargeable event (i.e. surrender of segments or a partial withdrawal which exceeds the cumulative 5% tax deferred allowance) can limit how much tax is payable on the bond gain.

Offshore bonds benefit from gross roll-up and are taxed as savings income when a gain arises. They are taxed after earned income, which includes pension income.

If someone doesn't take any drawdown income and has no other earned income their offshore bond gain can be set against the personal allowance, the starting rate for savings and the personal savings allowance. This would allow chargeable gains of up to £18,570 to be taken tax free in 2024/25.

Onshore bonds pay tax on the income and gains within the fund. There's a non-reclaimable tax credit of 20% given when there's a chargeable gain to reflect the tax already deducted.

This tax credit will satisfy the liability for non and basic rate taxpayers. Further tax is only payable if the gain when added to all other income in the tax year falls in the higher rate band and above. Reducing drawdown income, so that the top sliced gain sits within basic rate, can mean no further tax is due on the bond gain at all.

Collective investments

Reducing drawdown income can ensure a lower rate of CGT is payable on the disposal of unit trusts or OEICs.

Unit trusts and OEICs are subject to CGT on capital gains.

However, the rate of CGT payable is determined by an individual's income.

Capital gains are added on top of all income to establish the rate of CGT payable on the gains. Any part of a gain on the disposal of a unit trust or OEIC which falls below the higher rate threshold is taxed at 10% with all gains in excess of it taxed at 20%.