This little-known trick called 'phased drawdown' can help people approaching retirement maximise their income and reduce their income tax bill
With people now having much greater flexibility over when they can start taking pension income and how much they can take, there is a growing need for them to better prepare for the date when they start receiving their pension.
We are all eligible to receive 25% of our accumulated pension fund as tax-free cash – that’s free from any income tax – at the age of 55. But, depending on how you take that tax-free cash element, it could have an impact on the overall amount of tax you pay.
One of the legacies from the old pensions regime was that at the point of full retirement most people would take the 25% tax-free cash as a lump sum and put it in an interest-bearing account. They would then enjoy a regular income, provided by an annuity, that was bought with the remainder of the pension fund.
Now, because interest rates are so low there is a real danger that this approach will not provide you with an income that will keep up with inflation. That means that your retirement income will lose its buying power over the longer term.
When we consider that the CPI measure inflation currently stands at around 1.7% per annum, and one of the best interest-bearing easy-access accounts is paying just 1.46%, it’s easy to see that taking all your tax-free cash out of your pension to put it in a deposit account or Cash Isa is really not a great move if you don’t intend to spend it in the short term.
So how do you avoid this?
By using an appropriate pension provider who can facilitate ‘phased drawdown’, it’s actually pretty simple. Instead of taking out all of your tax-free cash in one go, this option allows you to enjoy your tax-free cash as part of your regular income.
Let’s look at a couple of theoretical examples of how this could work.
Austin is 64 and has retired before his state pension age of 67. He has taken a part-time job in a garden centre earning £6,000 a year. His personal tax allowance is £12,500 a year which means he has £6,500 still to utilise.
Via a phased drawdown arrangement, Austin can draw an annual income, through regular monthly income withdrawals, totalling £6,500 per year in order to use up the remainder of his personal tax allowance. In addition, he can take an extra £2,166 per annum (just over £180 per month) as tax-free cash.
This will mean he can receive income that is higher than the personal allowance without paying any extra income tax.
In total, Austin would be able to enjoy an annual income of £14,666 (£1,222 per month) without having to pay any income tax. That’s made up of £6,000 from his part-time job and a further £8,666 from his pension.
Sandra is 65. She retired before her state pension age and has no other earnings. To maximise her tax-free income, she withdraws £16,667 in total from her pension fund as annual income in regular monthly amounts. £12,500 of this uses up her personal allowance.
The additional £4,167 is the 25% tax-free cash element. That equates to £1,388.88/month tax-free income instead of the £1,041.67/month she would be eligible to under the personal allowance – that’s nearly £350 a month extra!
And that’s not quite where it ends.
If Austin and Sandra were married to non-taxpaying spouses, using the married persons tax allowance, they could both increase their own personal allowances by a further £1,250 per year. Then, utilising ‘phased drawdown’ could provide them with another £1,666 per year as a mixture of income and tax-free cash that would not attract any income tax liability.
When both Austin and Sandra qualify for their state pensions, they will need to recalibrate their withdrawal strategy to maximise their tax-free cash and minimise their income tax liabilities, however, the same principles apply.
It’s important to note that tax-free cash is available when you withdraw money from your pension fund on a ‘use it or lose it’ basis, so when you instruct your pension provider to release your monthly income you must always stipulate that part of it should be tax-free cash.
If you don’t, you could lose out and pay unnecessary tax on your hard-earned pension.
The added advantage of leaving your tax-free cash invested and only using it when you need it is that it will stay invested in your funds and continue its potential growth rather than sitting in a low paying interest account getting slowly depleted.
Ray Black is a chartered financial planner and founder of Money-minder.com
Any views expressed in this article are Ray’s own and do not represent the views of Moneywise or constitute financial advice. If you are unsure about the ideas expressed in this article, consult a financial adviser.