If you have a defined contribution pension (where what you pay in dictates what you can take out) rather than a Defined Benefit pension (where your employer pays you a promised income based on your length of service and salary) you will need to decide how you take the income, when you take the income, if you take the income, how much income you take.
In this article, we look at How can I take an income from my pension?
Firstly we will look at how a pension is taxed when you take benefits.
How is the pension taxed?
With a pension fund, you can take 25% tax free with the remaining 75% taxed as income. Traditionally, people took their tax free amount as a lump sum with the balance used to provide an income. Today this isn’t always the case.
Sometimes there may be an additional tax charge if you exceed the lifetime allowance. You can find more out about this here.
When can you take benefits?
You can take benefits from your pension any time after age 55. There are some instances when benefits could be taken before this however, I am not going to cover those here.
How can I take an income from my pension?
There are several options for how you can take benefits and I will cover each on in turn:
Take a tax free lump sum with no income
You can take your 25% tax free amount as a lump sum and leave the balance invested. You may wish to do this if for example you wanted to pay off your mortgage or another debt but didn’t need additional income.
When you take a tax free amount that “crystallises” that amount. To illustrate this, let’s say for example, you have a pension fund of £100,000. If you took your tax free amount of £25,000, the whole fund would be crystallised. This means that even if your £75,000 grew to £80,000, you would not be able to take an additional 25% from the £5,000 growth.
If you had a fund of £100,000 and you took £10,000 tax free, this would crystallise £40,000. £10,000 would be paid out. £30,000 would remain invested but would be crystallised. £60,000 would also remain invested but would be uncrystallised. You could take 25% tax free from the uncrystallised amount in the future. You cannot take any more tax free amounts from the crystallised element.
Lump sum – some tax free and some taxable
This is known as uncrystallised pension lump sum (UFPLS). It allows you to take a lump sum from the pension with 25% of it tax free and the rest taxed as income. Let’s say you had your £100,000 and you wanted £10,000 as a lump sum. Rather than the whole lump sum being tax free you could have 25% (£2,500) tax free with the balance (£7,500) taxed as income. Leaving the rest to be taken at a later date.
In this instance, if your earnings are below the personal allowance (currently £11,850), there would be not additional tax to pay on the taxed element. A basic rate tax payer would pay £1,500. A higher rate tax payer would pay £3,000 tax. By taking the tax free element and income at the same time, it can allow you to take an amount but minimise the tax paid without taking all of the tax free element at once.
In some instances, pension providers will apply emergency tax to such withdrawals. This can be reclaimed by using a P55 form which can be accesses here. However, this is something to be aware of.
The whole £100,000 could be taken as a lump sum however, it would incur up to £33,750 tax. Unless there is a very good reason for doing so, I would rarely recommend doing this.
Taking an income
You can use your pension to take income flexibly or you could purchase a guaranteed income.
Taking income flexibly
Income can be taken flexibly via drawdown. This allows you to take lump sums and or income payments. To start, stop, increase or decrease payments. It is important to be aware that your money will remain invested therefore, you will be taking on the investment risk and there is no guarantee that your money won’t run out.
You can take income by either crystallising:
- The whole amount – taking 25% tax free lump sum and using the balance to provide an income
- A small amount e.g. £40,000, taking £10,000 tax free and using the rest to provide an income or
- Small amounts each time you take an income payment so each withdrawal you take has a tax free element and an income element.
If you would like to find out more about taking a flexible income, read my blog here.
Taking a guaranteed income
You can use your pension fund to purchase an annuity. An annuity would provide you with a guaranteed income for the whole of your life or a fixed period of time. The amount that you receive will depend upon the fund value, your age, your health, whether you smoke, if you require a guarantee period, if you would like a spouse’s pension included and whether you want the income to increase. This can provide peace of mind that you will never run out of money. If you would like to find out more about annuities, read my blog here.
Things to be aware of
Not all pension plans will offer all options for taking benefits. Your provider will be able to let you know which options they offer.
Taking money out of a pension to put into your bank is not usually a good idea.
This is a complex area and there are lots of things to consider. If you are unsure, about your options, Pension Wise will be able to offer guidance but not advice. Here is the link to Pension Wise.
Taking too much money out of your pension could mean you pay more tax than you need to.
Taking too much out of your pension could deplete the fund entirely.
You will remain invested with all of the options above other than the annuity. It is therefore important that you ensure that you are invested appropriately for your risk profile and manner in which you are taking benefits.
Speak to a financial adviser.
If you would like a no obligation initial meeting, please contact me.