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Pension drawdown rules: what are they?

Posted By The Accumulator On In Deaccumulation,Investing | 118 Comments

I have always found it hard to keep a grip on the pension drawdown options. There are so many fiddly yet peskily important details to forget about.

So today we’ll try to capture all the crucial drawdown details in one place for future reference.

Let’s take it one step at a time…

What is a drawdown pension?

Going into pension drawdown is one of the options you have when taking money from a defined contribution pension of some description.

Defined contribution pensions have more aliases than a criminal mastermind, including:

There’s even more out there if you look for them!

Meanwhile, a defined contribution pension is best described as not a defined benefit pension.

A defined benefit pension offers you a guaranteed income for life.

A defined contribution pension does not, and so is not as good. It is however typically cheaper and less burdensome for a company to offer to its workers than a defined benefit jobbie. Which is why defined benefit pensions are nowadays rarer than unicorn milk in the private sector.

If you’re under 60 and you work in the private sector, you most probably [1] have a defined contribution pension.

This article focuses purely on your options if you hold a defined contribution pension. Mostly because that’s the type I have too – and because I have to draw the line somewhere.

I’m also going to assume that the earliest you can retire is age 55 (going up to 57 from 6 April 2028) and that you don’t have any other pension bells and whistles like lump sum protections and the like.

We can investigate the exceptions and edge cases together in the comments.

Pension drawdown: take a step back to go forward

When you crack open your pension pot, you can take some of your savings as tax-free cash (TFC)1 [2] – which is every bit as good as it sounds.

The rest of your income needs are serviced by taxable cash.

There are three main options for releasing the taxable wedge from your pension, and we’ll come to those in a sec.

How much tax-free cash?

You can take up to 25% of your pension savings as tax-free cash.

Your tax-free cash is currently capped at £268,2752 [3] (known as the lump sum allowance) or 25% of the lump sum and death benefit allowance (LSDBA) of £1,073,100.3 [4]

You can take your entire tax-free cash allowance in one go, or in stages. It’s up to you.

Options for your taxable pension savings

For every £1 you take in tax-free cash, you have to decide what to do with the other, potentially taxable £3:

Pension drawdown – you can take a flexible income from your pot while the rest of your funds are typically left invested.

Buy an annuity – you hand over a sizeable chunk of your loot to an insurance company. It then pays you a regular income for as long as you wear this mortal coil.

Cash grab – you can take your entire pension as cash NOW. Or some of it. This is the Lamborghini [5] option. Or a Vauxhall Corsa in my case. HMRC will send you a birthday card if you go down this route. Sorry, that should read enormous tax demand.

Have it your way – mix-and-match the three options above, in any combination you like, Burger King-style.

Your provider may not offer all or even any of these options. In which case you can transfer your pension [6] to someone who will.

Okay, I’d love to talk about pension drawdown now. But, to do that, I’ve gotta get some more confounding terminology out of the way…

Crystallised versus uncrystallised pension

There’s no escaping this.

Your pension stands astride a boundary. Not the line betwixt good and evil but between uncrystallised and crystallised.

Uncrystallised pension savings refer to pension assets that are not ‘in play’. They remain invested in your pension pot, poised in a superposition. All options are still on the table, because you haven’t yet entangled them in a withdrawal event. [Editor’s note: Great thinking @TA – using a quantum mechanics metaphor to simplify pension chat!]

Crystallised pension savings are assets that are ‘in play’ because you’ve withdrawn money.

For example imagine you withdraw 10% of your £500,000 pension as tax-free cash.

This crystallises £200,000 like so:

To recap: your remaining £150,000 of crystallised funds can be put into drawdown, some portion can be used to buy an annuity, or you can stuff the lot into a holdall before going on the run from HMRC.

All that means that £300,000 of our original £500,000 pension is still uncrystallised. And 25% of that £300,000 can still hatch as tax-free cash.

Crystal clear-ish

Perhaps the best way to think of the metamorphosis between uncrystallised and crystallised pension is that income is taken from the crystallised portion and may be subject to income tax at your marginal rate.

A diagram showing how the pension drawdown rules work [7]

Lots of sources describe crystallising pension assets as ‘cashing in’ your pension. This doesn’t make sense to me. You can leave crystallised funds invested and untouched for the rest of your life if you want.

Importantly, when you crystallise an amount, you lose your right to its associated 25% tax-free cash if you don’t take it at the time.

Incidentally, your pension is not subject to Inheritance Tax – no matter which state it’s in.

Pension drawdown rules

At last! With that foundation course out of the way, we can move on to the actual pension drawdown rules.

Pension drawdown is extremely flexible, subject to the confines of your provider’s scheme.

If you take 25% of your pension pot as tax-free cash then the remaining 75% can be put into drawdown as discussed.

From there, you can start taking an income from these crystallised funds. As frequently as monthly if your broker’s particular platform is game.

That’s one way of doing it.

However a better way for many people is to periodically take tax-free cash in chunks. For example, in amounts that don’t exceed your annual ISA allowance [8], so you can then tuck the cash away in an ISA where it can continue to grow tax-free.

This approach is known as phased drawdown or partial drawdown, because every tax-free withdrawal also crystallises additional assets in the 3:1 ratio described above.

Phased or partial drawdown

Phased drawdown isn’t a special pension drawdown mode you need to unlock. It’s just a name given to drawing down in stages, as opposed to taking all of your tax-free cash in a one-er.

Here’s an example of phased drawdown:

A table showing how the pension drawdown rules work [9]

I’ve streamlined this example. There’s no need to crystallise the same amount every year with phased drawdown.

I’ve not stuck to my sustainable withdrawal rate [10] in this example either. And it illustrates a mild investing nightmare, as the portfolio has gone sideways for two years on the trot.

Remember that any amount of the £30,000 crystallised segment can be taken as income too (or none of it), but these withdrawals are subject to income tax once you’ve smashed through your personal allowances.

Phased drawdown has two advantages versus the other method of withdrawing from your pension in stages: the uncrystallised funds pension lump sum (UFPLS).

Firstly, phased drawdown doesn’t trigger the Money Purchase Annual Allowance [11] (MPAA) rules. Just so long as you don’t take an income from your crystallised funds.

In other words, you won’t limit tax-relief on your future pension contributions if you can live off your tax-free cash and/or other income sources for a time.

Secondly, tax-free cash from drawdown isn’t restricted to 25% of the standard limit if you have pension protections that exceed that limit.

Capped drawdown

Capped drawdown was a more restrictive set of pension drawdown rules that applied before the shackles were loosened.

You can’t choose capped drawdown as an option anymore. You can decide to remain on it though.

Pension drawdown tax

Any money withdrawn from your pension drawdown assets (aside from your tax-free cash) is subject to income tax as normal.

These withdrawals count as non-savings income that is taxed in the same way as wages from a job.4 [12]

The first £12,570 taken from your pension drawdown balance is tax-free due to the personal allowance. All the usual tax bands and rules apply thereafter.

Treat the family by dying before age 75

If you die before age 75 then any beneficiary can take an income from your drawdown pension tax-free. This is known as beneficiary drawdown but it isn’t available from all schemes. The same goes for annuities.

If you die before age 75 then any lump sum payments in excess of the lump sum and death benefit allowance are taxable at your beneficiary’s marginal income tax rate.

After age 75, all payments are made at the beneficiary’s marginal income tax rate.

Obscure exception 1: Income tax is payable at the beneficiary’s rate if you die before age 75, and payments are taken from uncrystallised funds that are not designated for drawdown within two years of the scheme administrator knowing about your death.

Obscure exception 2: Income tax is payable at the beneficiary’s rate if you die before age 75, and a lump sum is taken beyond two years of the scheme administrator knowing about your death.

Obscure exception 3: Income tax is payable at 45% on lump sums paid into a trust, if you die after age 75.

Note: Taking income from an inherited pension does not trigger the Money Purchase Annual Allowance.

Emergency tax on pension drawdown payments

Tax on pension withdrawals is deducted by your broker/scheme provider using PAYE.

Your first drawdown payment (or any that are deemed to be ad hoc) is likely to be taxed using an emergency tax code rather than your actual rate.

Look out for an ‘M1’ suffix on your tax code e.g. 1257LM1.

This indicates your payment is taxed on a Month 1 basis.

The M1 means HMRC will multiply that payment by twelve as they assume that you’ll receive the same amount of income every month.

For instance, if you take £20,000 (above and beyond your tax-free cash) to cover the year, HMRC will calculate that you must be living it large on a £240,000 annual income.

Obviously paying tax at that rate is going to take a massive bite out of your £20,000 income apple. It could be months before you’re refunded by HMRC.

It’s a patently ludicrous situation.

You can reclaim the tax (see below) but that takes time.

Cracking the code

After that initial tax bill shock, you’re on HMRC’s pension payment radar. They should issue you (and your pension provider) with a tax code that’s based on how much tax you’ve already paid this tax year.

Now you’re being taxed on a cumulative basis, which is how we’re all used to being treated when we’re paid a monthly salary.

A standard tax code like 1257L shows you’re being taxed on a cumulative basis i.e. the M1 has been lopped off.

With a cumulative basis tax code in play you should be taxed properly on any regular withdrawal schedule agreed with your pension provider.

So if they offer you payments on, for example, a quarterly or annual regular withdrawal schedule, HMRC should tax those on the basis that they amount to 25% or 100% of your annual income.

Any under or overpayments of tax will be clawed back or refunded through your future regular income drops, and HMRC will automatically issue new tax codes to your provider to make it so.

As mentioned, ad hoc payments are always treated on an M1 basis, so they have the potential to knock things sideways tax-wise.

Quilter has provided an excellent explanation [13] of how pensions and PAYE interact. Many thanks to Monevator reader Tricky for linking to this in the comments.

Deescalation

I’d recommend having a conversation with your broker about how you can duck the emergency tax bullet – but it seems to be unavoidable because this is how PAYE works.

There do seem to be two ways to mitigate the tax hit on your first pension payment:

This way, HMRC is effectively reclaiming the correct amount of tax from you. There’s lovely!

Choosing your regular income schedule

Perhaps your broker manages their system on a VIC-20, or you want payments aligned with the lunar months?

Either way, your pension provider may not be able to provide you with a satisfactory schedule of regular payments.

In that case, my personal preference would be to sell down enough bonds and equities to cover myself for the time period in question e.g. a year. Then I’d park the cash in my pension – possibly using a money market fund [14] if my broker’s interest rate is rubbish. Finally, I’d take monthly payments (or whatever schedule the provider can offer) from that cash balance to keep things square with HMRC.

Relatedly, Monevator reader Gizzard points out that some lenders will only look at monthly income payments when assessing your credit worthiness. So your clockwork annual payments may get disregarded as ‘unusual’ lump sums.

Reclaiming tax

Just for fun, HMRC have three different tax forms on the go for reclaiming tax on pension withdrawals. Choose from:

When you plan to take multiple withdrawals from a pension then HMRC will revise your tax code later in the year for under/overpayments. Thus we’re spared another tax form.

Pension drawdown charges

You shouldn’t have to pay anything for drawdown services these days.

See the SIPP row / Fee notes column of the Monevator broker table [18] to find drawdown and UFPLS fees.

Fidelity, AJ Bell, Aviva, and Hargreaves Lansdown all charge nothing for drawdown. And they cap their platform charges at a reasonable rate if you choose an ETF-only portfolio [19].

Small pots

The small pots rule allows you to empty three defined contribution pensions worth up to £10,000 each but with two additional bonus features that you may wish to know about.

Firstly, the small pots rule works like the cash grab option we described earlier:

However, you must empty a small pot completely when using this rule. You can’t leave the money hanging around, so watch out for any tax consequences that follow from withdrawing your 75% taxable cash.

The two small pots bonus features are:

So you may be able to rearrange your pensions to squeeze out another £7,500 in tax-free cash using small pots.

Check with your pension provider to ensure your scheme is eligible for the small pots rule.

You may well pay the wrong amount of tax initially on a small pots withdrawal as the basic rate is automatically applied to the taxable element – regardless of any other tax you’ve paid in the year.

The rules are different if your defined contribution scheme is classified as an ‘occupational pension’ [20] scheme, although few are, apparently.

Pension Wise

Finally, if you would welcome advice on how to make the most of your pension then know that you are entitled to a free Pension Wise advice session [21].

Doubtless even grizzled Monevator mavens [22] would benefit from the chance to clarify things. You can also attend an appointment on behalf of a family member or a friend.

Given the life-changing nature of these decisions, I’m very glad that Pension Wise exists to offer a guiding hand. Even if only for 60 minutes.

As for us, that’s it for our tour of the pension drawdown rules.

Complexity seems to be the necessary by-product of the UK’s flexible pension system. I hope this piece goes some way to clearing up the fug surrounding it.

But let us know what we’ve missed in the comments below.

Take it steady,

The Accumulator

PS – check out HMRC’s pension tax manual [23] if you’re having trouble sleeping at night.

  1. Also known as the pension commencement lump sum or PCLS. [↩ [28]]
  2. Unless you’ve already locked-in a higher lump sum or lifetime allowance limit. [↩ [29]]
  3. The pale shadow of the Lifetime Allowance. [↩ [30]]
  4. Though pension withdrawals do not count as earnings that determine how much you can contribute towards a pension. [↩ [31]]