Income drawdown is a way of getting pension income when someone retires while allowing their pension fund to keep on growing. Instead of using all the money in a pension fund to buy an annuity, individuals leave their money invested and take a regular income direct from the fund.
Clare Moffat, pension expert at Royal London spoke exclusively with Express.co.uk about the impacts of drawdown.
She said: “It’s important that people fully understand all their options in relation to drawdown when it comes to accessing their pension savings especially if they are still working, and take the necessary steps to make sure they don’t outlive their retirement income.
“If you are still working and want to carry on paying into your pension then it’s important that you only take out your 25 percent tax free cash and move the other 75 percent into drawdown.
“This is because once you start accessing even £1 of income from your drawdown pot, you will face restrictions on how much you can save into a pension as the Money Purchase Annual Allowance (MPAA) will apply.”
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The MPAA is a special restriction on the amount people can pay in to their pension and still receive tax relief.
MPAA kicks in when someone starts to access their pension pot for the first time.
The maximum someone and their employer can save into defined contribution pensions, without a tax charge, reduces from £40,000 to £4,000 annually.
But it does not apply to taking their 25 percent tax free lump sum or cashing in three small pots of less than £10,000 each.
Ms Moffat explained if an individual is still in employment, or running their own business, and they don’t trigger the MPAA, it means they can continue paying into their plan which will allow them to benefit from tax relief on their contributions.
She said: “You don’t need to take 25 percent of your total pension pot as tax free cash and can instead take out a smaller amount and take more tax-free cash later.
“For example, if you have a pension pot of £100,000 – you can take out £25,000 tax free and then move £75,000 into drawdown.
“But if you want the money for a £10,000 holiday then you could just take £10,000 out of our pension pot, move the other 75 percent – £30,000 – to drawdown and leave £60,000 in your pension pot.
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Any income taken above one’s tax-free cash and their personal allowance will be taxed as earned income.
HMRC will calculate the tax people need to pay and tell their pension provider what deductions to make.
Ms Moffat warned: “Be aware that taking large sums out could push you into a higher tax bracket. But one of the benefits of drawdown is that you can make sure you stay within a certain tax bracket.”
She explained depending on performance, the retirement savings pot could actually grow, even as people are taking money out.
If there’s still money remaining in one’s pot when they die, this can usually be passed to loved ones free from inheritance tax.
She concluded: “The chief disadvantage of drawdown is that you could run out of money before you die, whereas with an annuity you can secure a fixed income which will last as long as you do.
“Taking financial advice is very important as this will help to make sure you have enough to last for your lifetime.”