What is Income Drawdown?
Income Drawdown is a method of accessing the tax free lump sum, an income or both from your pension fund without having to commit to a Lifetime Annuity.
Income Drawdown is generally aimed at the more financially aware investor and tends to attract the larger pension funds although the minimum amount that can be invested varies from company to company.
When can it be used?
Income Drawdown can be used at anytime between the ages of 55 and 75.
For those who have built up sufficient provision to meet their retirement goals taking benefits at 55, which is earlier than a traditional retirement age, should not cause financial hardship. However taking retirement benefits early is unsuitable in many circumstances and will reduce income in retirement.’
‘Before drawing early on your pension to meet a specific financial need other than retirement income you should consider firstly accessing other savings and investments as alternative sources of funding’.
Income Drawdown can be used in a variety of circumstances, for example:
- If you wish to take an income but for whatever reason, you decide that you’re not ready to buy a Lifetime Annuity
- If you wish to access your tax free lump sum (also known as Pension Commencement Lump Sum or PCLS) but do not wish to take an income
- If you want more flexible benefits than a Lifetime Annuity can provide
- If you require a flexible income level, for example if partially retiring
- If you believe that annuity rates are poor and hope that they will improve over time and as you become older; obviously an improvement in Annuity rates is far from guaranteed
Your current pension fund is either converted into Income Drawdown, or more usually, you transfer into a new one. You decide, up to the maximum available, what amount of tax-free cash you want and this is paid to you straightaway. If you decide not to take the tax free cash at retirement, it cannot be withdrawn subsequently.
If you do not want the full amount, you should consider a Phased Retirement plan or a combination of both.
The maximum tax free cash sum that you can take is 25% of the value of your pension funds
The remainder of your fund is invested, from this fund; you may withdraw an income each year. The income you draw will be taxed as earned income, with tax deducted at source.
From 6th April 2011 there will be two forms of Income Drawdown, namely Capped Drawdown and Flexible Drawdown:
“Capped Drawdown” Once a fund is crystallised and any tax free lump sum is paid out, the remaining fund can be used to purchase an Annuity or moved to Income Drawdown.
No minimum income must be taken, however there is a maximum amount of income which is available. The maximum annual income which can currently be taken is 120% of a single life, level Annuity based on the tables provided by the Government Actuary’s Department (GAD). This is being reduced to 100% from 6th April 2011 The income limits are also currently reviewed every five years before age 75. This will change to every three years from 6th April 2011, or when the next five year review is due, whichever is later for existing Income Drawdown plans.
This means that going forward the amount of income that can be taken will be broadly similar for annuities and Capped Drawdown. At present the maximum income which could be taken from an Income Drawdown contract is generally higher than an Annuity.
Capped Drawdown will have no maximum age. Age 75 will however trigger a change in the frequency of maximum income reviews; from every three years prior to age 75 and every year thereafter based on the individual’s age (the GAD tables will be extended). The increased frequency and use of actual ages will ensure there is less chance of fund erosion.
“Flexible Drawdown” Flexible Drawdown is a new introduction and will be available to individuals that have secure pension income equal to the Minimum Income Requirement (MIR) in the tax year that Flexible Drawdown commences.
The aim of the MIR is to prevent a member from exhausting their pension funds and falling back on the state.
Initially the MIR will be set at £20,000 a year and there is an intention that this will be reviewed by the Treasury every five years, it will not be index-linked on an annual basis.
Only particular types of pension income will count towards the MIR, such as income from:
- Lifetime annuities
- Scheme pensions e.g. from a defined benefit scheme
- State pensions
Drawdown income is excluded because it is not secure for life.
Where an individual satisfies the MIR they can enter Flexible Drawdown which will allow them to draw as much as they like from their arrangement without limit, but subject to tax at their highest rate.
To prevent abuse of the new rules in the year of commencing Flexible Drawdown no contributions can be made to a defined contribution scheme and the individual must cease to be an active member of any defined benefit scheme.
In addition once Flexible Drawdown has commenced, any further pension contributions will be subject to the annual allowance charge. For these reasons Flexible drawdown should only be used when an individual is sure that they have made all the pension contributions they wish to.
In both forms of Income Drawdown the income level is chosen by the investor, and can change according to personal circumstances. There is no minimum level of income that needs to be taken, which means that the investor can take the tax-free cash alone and defer income to a later time.
Whether you are in Capped or Flexible Drawdown there are two options for taking an income from the Income Drawdown plan:
Short Term Annuity With a Short Term Annuity, you can use all or part of your pension fund to buy a Fixed Term Annuity lasting up to five years. You can choose your annuity options in much the same way as a Lifetime Annuity. In the meantime, the remainder of your fund continues to be invested. At the end of the Annuity term, you can buy another Fixed Term Annuity.
Directly from the fund You can take an income direct from your pension whilst the fund remains invested in line with your attitude to risk.
You could at any time nominate specific dependants to receive benefits on your death. If you do this, on your death each nominated dependant will have several options available in respect of his or her share of the fund:
- He or she can choose to buy an annuity immediately
- The fund can be taken as cash, less a tax deduction, which is currently set at 35%, rising from 6th April 2011 to 55%
- He or she can continue with the Income Drawdown arrangement
From 6th April 2011 there will no longer be a requirement to secure an income, generally in the form of an Annuity, before age 75.
- You can access the tax free lump sum without having to take an income
- If you or spouse are relatively young, this makes a Lifetime Annuity purchase relatively less attractive, therefore you can take advantage of a longer timescale in which to take on the rewards and risks associated with equity-based investment
- If you decide to take an income, then subject to the maximum allowable amount, the level can be flexible to fit with your circumstances
- For those who qualify Flexible Drawdown will allow more income to be taken than has previously been the case
- Your pension fund continues to be invested and can continue to grow in a tax efficient environment
- The options available on death are more flexible than with a Lifetime Annuity
- If you believe that interest rates, and therefore Annuity rates, are temporarily at low levels and might increase again in the future you may prefer to delay the purchase of an Annuity
- It gives you the option to wait until health deteriorates to then take advantage of an enhanced or impaired life annuity
- There are often relatively high charges for the considerable amount of administration and advice involved in running an Income Drawdown arrangement
- Future investment returns are unknown and the value of funds will fluctuate over time
- A combination of poor investment returns and high income withdrawals can reduce the value of your remaining fund. Withdrawing too much income in the early years may have an adverse effect on preserving the pension purchasing power or preserving the capital value of your fund
- By investing in safe investments like cash and fixed interest securities, you are likely to receive a lower lifetime income than is available from an Annuity, which has the advantage of the mortality factor
- Taking high levels of income could erode the fund and as a result you may not be able to draw as much income from your fund as you had expected
- Mortality drag means that you will not benefit from the cross subsidy created by those people that buy an Annuity and die before they are expected to do so
- There is no guarantee that Annuity rates will improve in the future or that the income you get from the Income Drawdown plan will be as high as a Lifetime Annuity
- Your income could be reduced at one of the periodic reviews
Making the decision between a Lifetime Annuity or Income Drawdown requires careful consideration and full knowledge of all the options available to you.
We have a number of additional resources for you to help you make a decision.
The following FSA guides are available:
Additionally you can contact us to obtain advice with regard to your options in retirement by calling us on 0845 074 7778 or 0115 933 8433. Alternatively send an email to email@example.com
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Whatever route you pursue, take advice. The decisions you make will effect your income for the rest of your life.