Understand pension drawdown

With income drawdown – also known as 'flexi-access drawdown' – you keep most or all of your pension pot invested and draw an income from it.

Unlike an annuity, the income isn't guaranteed for life, so this option carries more risk that your money might run out before you do.

However, in return for more risk you do gain more flexibility with income drawdown as you can vary the amount you take according to your need.

Setting up your scheme

When you first set up your income drawdown scheme you can choose to take up to 25% (a quarter) of your pension pot as a tax-free lump sum.

You move the rest into one or more funds that allow you to take a taxable income in amounts and at times to suit you. Most people use drawdown to take a regular income.

You will have to choose funds to keep your money invested in that match your income objectives and your attitude to risk. These funds might be with your current pension provider or a different one

Once you’ve taken your tax-free lump sum you can start taking your income right away or wait until a later date

You are not locked into your income drawdown scheme – you can at any time use all or part of it to buy a more secure retirement income product such as an annuity.

Deciding how much income you can afford to take under income drawdown needs careful planning. It depends on:

• the size of your income drawdown fund
• the performance of the funds over time
• what other sources of income you have – see previous section
• whether you want to provide for someone else after you die
• how long you expect to live

Depending on inflation, the performance of your investments, and any changes to your income needs, you may need to adjust the income you are taking periodically.

If you are not sure where to start, a good rule of thumb is to take a maximum of 4 per cent of your pension pot as income in the first year and in subsequent years increase this amount by inflation each year.

Research has shown that this approach means your fund has a good chance of lasting throughout life. However, this will still depend on the performance of the funds you are invested in.

Go to the income estimator to find out how long your money might last depending on how much income you draw from your pension pot.

Budgeting

It's not just your income that's likely to change in retirement, your spending will too. For example, you may no longer have to pay fares to get to work but if you spend more time at home your household bills may increase.

If you draw up a budget of how much you're likely to spend when you retire you will have a clearer picture of how much income you will need overall. This in turn will help you work out how much you'd need to take under income drawdown when taking into account your other sources of income.

You pay tax on your income withdrawals at your appropriate Income Tax rate, taking into account your overall income.

If you have other income, for example from earning, rent or investments, you'll need to plan carefully how much drawdown income to take, to avoid pushing yourself into a higher tax bracket.

Income Tax rates 2020 - 2021: England, Wales and Northern Ireland

Income Tax Band	Your income	Income Tax rate
Your personal allowance 1	Up to £12,500	0%
Basic Rate	£12,501 - £50,000	20%
Higher Rate	£50,001 - £150,000	40%
Additional Rate	Over £150,000	45%
1 The personal allowance is the amount of income you can have before you have to start paying Income Tax. When your income is over £100,000, your personal allowance reduces by £1 for every £2 above the limit.

Income Tax rates 2020 - 2021: Scotland

Income Tax Band	Your income	Income Tax rate
Your personal allowance 1	Up to £12,500	0%
Starter Rate	£12,501 - £14,585	19%
Basic Rate	£14,586 - £25,158	20%
Intermediate Rate	£25,159 - £43,430	21%
Higher Rate	£43,431 - £150,000	41%
Additional Rate	Over £150,000	46%
1 The personal allowance is the amount of income you can have before you have to start paying Income Tax. When your income is over £100,000, your personal allowance reduces by £1 for every £2 above the limit.

Your drawdown provider will pay the cash and take off tax in advance from any income you take – called PAYE (Pay As You Earn). This means you may pay too much tax and have to claim the money back – or you may owe more tax if you have other sources of income.

Tax relief on future pension contributions

You can set up an income drawdown scheme and continue paying into a pension, but the maximum annual pension contributions you can get tax relief on once you start taking income under drawdown is £4,000 (or the amount of your earnings if it's less). This is down from the usual Annual Allowance of up to £40,000. If you want to carry on building up your pension pot, this may influence when you start taking your drawdown income.

The tax relief you get for future pension savings is not affected if you take the tax-free lump sum but no income.

If you're not earning, you can still get tax relief on contributions up to £3,600.

Lifetime allowance

The maximum pension savings you can build up without incurring a tax charge when you draw out your savings (and without leaving a tax charge for your beneficiaries if you die before age 75) is £1,030,000. If your pension pot is worth more than this, you'll pay tax (25% on income and 55% on cash lump sums) when you withdraw the excess amount.

The tax rules for passing on your unused drawdown fund are set out below. Be sure to complete an expression of wish form to say who should inherit what’s left when you die. If you don't, your estate may have to pay unnecessary Inheritance Tax. When you die, whoever is dealing with your estate must notify your pension provider of your death.

If you die before you're 75, any remaining income drawdown fund passed to your nominated beneficiary within two years is tax free. They can take this either as a lump sum or as income. However, if the money is claimed more than 2 years after your death, any money paid will be added to the beneficiary’s income and taxed at their appropriate rate.

If you die aged 75 or over, any lump sum or income paid to your beneficiary is added to the rest of their income for the year and taxed at their appropriate tax rate.

Income drawdown requires an active investment strategy. This means choosing a mix of investments that will produce an income at the level you need to last throughout your retirement and with enough spread of risk to ride out the peaks and troughs of stock market movements.

To achieve the right balance you will normally to need to mix (or 'diversify') your investments across a range of 'assets' such as cash, shares, property funds, corporate bonds and so on. You also need to be ready to react if markets change significantly, and know when's the right time to move your investments into more secure funds as you grow older.

Choosing the right pension drawdown scheme is complex. Different schemes have different charges and some are more flexible than others. For example, in theory, you should be able to alter the amount of income you take or withdraw ad hoc amounts. In practice this may not be as simple as it seems and you are almost certainly going to be charged for it. So when you are choosing a scheme, check the charges and ask how flexible the provider can be.

If you are at all unsure we strongly recommend you get help from a regulated financial adviser. Although you will have to pay for the advice, it could save you money in the long run.

Can you buy direct?

Some of the drawdown providers listed will deal direct with you, but it's unlikely that they will offer you advice in terms of what funds to invest into and how much to draw. Instead you will have to make these decisions yourself. This is fine if you know what you are doing, but if you make a mistake you can't later complain.

Also if you go direct to a provider you will normally only be offered the choice of one product.

Bear in mind that if you buy without advice the cost of the provider's service will most likely be built in to the product charges, and won't necessarily be any cheaper than getting advice.

We suggest you compare the pros and cons of buying direct against buying through a regulated financial adviser.