Traditionally, tax-free cash has been received as a lump sum at retirement and used to pay for things that might otherwise be unaffordable: paying off the mortgage, perhaps, or buying a dream car or holiday. This approach was often justified because tax-free cash was the only way to draw a large lump sum from a pension and being tax-free the timing of the payment in the tax year didn’t matter.
Freedom and Choice has given savers greater control over their retirement savings allowing them to take all their benefits in one go from age 55 if they wish. This increased flexibility means that tax-free cash is no longer the only way to receive a large payment from a pension, which has freed up the tax-free cash to be used for other purposes. Many will still take their tax-free cash in one go, particularly if their earnings remain high at retirement and they want to avoid high rates of income tax, but others may be able to utilise the lump sum to increase the tax-efficiency of the withdrawals they receive from their pension pot.
Drip-feed drawdown enables clients to do this through Retirement Account. The concept is straightforward: drawdown income and tax-free cash are taken together on a periodic basis (monthly, half-yearly etc.) with the flexibility to change the amounts they receive at any time. The tax-free cash component will be between 25% and 100% of the total payment and this can be varied to tie in with the client’s requirements. As part of the payment is made up of tax-free cash, the income tax liability will usually be lower than if the full amount was received as drawdown income. Equally, as the payment is not solely comprised of tax-free cash (unless they use the 100% tax-free cash option) more is retained for the future, which will also increase in line with the investment growth the pension fund achieves.
Another benefit is that by paying less tax on withdrawals now – and particularly in the early years - more funds can remain invested and have a longer opportunity to produce further growth. This also fits in with a general principle of tax-planning: pay the lowest amount of tax you can using available allowances and tax bands.
The example shows how drip-feed drawdown can be used by a low earner.
Mitch, who has recently retired aged 63, receives an annual final salary pension of £8,500. He has £170,000 in a personal pension. To meet his needs, he requires £16,500 per annum and wants to draw from his personal pension for a few years until he takes on a low-skilled part-time job to supplement his income. He wants to make sure his personal allowance is not wasted so he requires some taxable income. An £8,000 withdrawal is made from his pension through drip-feed drawdown made up of £4,000 tax-free cash and £4,000 taxable income. The latter income plus his final salary pension of £8,500 use up all of his £12,500 personal allowance (2019/20), meaning the full £16,500 can be received free of tax.
Drip-feed drawdown has allowed Mitch to take just the right amount of taxable income to use up his personal allowance. To account for indexation to his final salary pension and tax bands, he can adjust the mix of income/cash whenever he needs to. The above example demonstrates how someone can use drip-feed drawdown to maximise use of the personal allowance at retirement. It can also be used as people with higher income levels move more gradually into retirement.
Kathryn, aged 57, plans to reduce her hours with her salary of £55,000 dropping by £10,000. She needs to maintain her standard of living so needs to access her personal pension (fund £650,000). The £10,000 drop in income Kathryn is replacing would have given rise to £3,000 income tax, leaving a net income payment of £7,000 (£5,000 taxed at 20% and £5,000 at 40%; for simplicity the example does not account for Employee’s NI liability.)
The most tax efficient route to meet this need is to utilise drip-feed drawdown to pay out £7,000 comprised of £3,000 in tax-free cash and £4,000 in post-tax income. This would have required £12,000 to be crystallised, £9,000 of which was designated to drawdown. Drip-feed drawdown automatically drew £5,000 income, which after £1,000 income tax at 20% was deducted through PAYE, left a net withdrawal of £4,000. This together with the £3,000 tax-free cash provided her with a total of £7,000.
The above approach optimises the use of tax-free cash ensuring the taxable withdrawal remained within Kathryn’s basic rate band. Despite the payments in the examples being made up of tax-free and taxable components the client will receive one single amount each time. The necessary crystallisations, drawdown designations and lifetime allowance tests all take place in the background, providing the client with a simple, flexible and potentially tax-efficient way of accessing their money purchase pension funds.