Why You Need To Plan When Taking Drawdown | moneyfacts.co.uk

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Derin Clark

Derin Clark

Online Reporter
Published: 20/08/2021

Retirees planning to fund their retirement through pension drawdown may be tempted to take the full 25% tax-free drawdown in one lump sum, but for many pensioners it may be a better option to think more strategically about how they release their pension savings.

What is drawdown?

Traditionally, when retiring consumers would only have the options of taking out an annuity. Since the pension freedoms were introduced in 2015, an increasing number of retirees have been opting for drawdown over the previously the annuity option as it allows them to have more control over their pensions.

With drawdown, retirees can release money from their pension pots gradually as, and when, they need it. This means that the remainder of their pension savings can stay invested, which, depending on their investments, can result in their pension continuing to accumulate returns.

A major benefit of taking drawdown is that the first 25% can be taken tax-free which, can significantly help to boost pension incomes. Despite the tax benefits and level of control pension drawdown brings, those considering drawdown need to carefully plan how much and when they release money from their pension savings as, if they get it wrong, it could result in running out of money later in life.

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Taking the 25% tax-free pension drawdown

The first 25% of pension pots can be taken tax-free. Retirees have two options when taking their tax-free savings – the first is to take the entire 25% as one lump sum and the second is for the first 25% of each pension drawdown to be taken as tax-free income. As an example, with the first option, someone with a pension pot of £150,000 would be able to take a lump sum of £37,500 and then income from the remaining savings would be taxable. Meanwhile, with the second option, if someone was taking regular pension drawdown of £1,000 the first £250 of each drawdown would be tax-free, with the remaining £750 taxable.

The dangers of taking 25% drawdown lump sum

Whether to pay for home renovations, go on a trip of a lifetime or help family members onto the property ladder, there are many reasons why it can be tempting to take the 25% tax-free lump sum when retiring, but this could be an inefficient way to use the tax benefit of pension drawdown. The main reason why it may be better off taking the tax-free sums gradually is that the more money that is left in the pension pot the higher the likelihood that it will earn higher returns, which could result in a larger pension pot and possibly replace the money that has already been withdrawn.

Another reason why retirees may want to avoid taking the tax-free lump sum is the impact it can have on inheritance tax. Currently when someone dies, up to £325,000 of their estate, which can include any property and savings, is not subject to inheritance tax, whereas any assets over this amount are liable to inheritance tax. Pensions, excluding annuities, can however be inherited and are not liable to inheritance tax no matter how much is saved within the pot. This means that if a retiree takes the full 25% tax-free lump sum when they retire, the money will be included as part of the overall estate, which could result in beneficiaries of the inheritance having to pay inheritance tax on the money. If, however, the money remains within the pension, it can be inherited without having to pay inheritance tax, although income tax may be payable by the beneficiary.

Planning pension drawdown

When looking into taking the 25% tax-free pension drawdown retirees clearly have many factors to consider and should plan carefully how to benefit the most from the tax-free pension withdrawal. For this reason, it may be worthwhile speaking to an independent financial advisor before retiring to discuss the best ways to take pension drawdown and how to efficiently use the 25% tax-free drawdown.

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