How do pensions work when you retire?
After decades of working and building your pension pot, you’ll want to ensure you’re making smart money decisions when you retire to support you through later life.
If you’ve been contributing towards a workplace or private pension, you should be able to access it from the age of 55 (rising to 57 from April 2028). Once you reach this age, there are several ways you can access and use your pension pot.
What are my pension options?
Depending on your personal circumstances, you may choose to take your pension in one of the following ways.
Lump sums
When you retire, you will usually have the option of taking cash lump sums from your pension pot. This can be done as one complete cash withdrawal, or as several cash withdrawals over the course of your retirement. Both options allow you to take 25% tax free.
If you choose to withdraw your entire pension pot as one lump sum, 25% of that amount will be tax free. Similarly, if you choose to take smaller amounts throughout the course of your retirement, 25% of each lump sum withdrawal will be tax free.
As an example, if an £80,000 pension pot was taken as one lump sum, £20,000 of that amount would be tax free. If you were to withdraw £2,000 each month, £500 of that amount would be tax free.
If you choose to withdraw more than 25%, you will be taxed at the same rate as any other income which may push you into a higher tax bracket.
Annuities
An annuity is an insurance policy that you purchase with your pension or other savings, to provide you with a guaranteed regular income.
Annuities give you the security of knowing you have a fixed and regular income, either for a set period or for the rest of your life. It takes away the responsibility of managing your own pension pot and you could get an enhanced annuity (with a greater income) if you suffer from ill-health.
Bear in mind that not all annuities let you pass money on to your loved ones when you die, and you can’t change your mind once they’re set up. There is also usually a fee for setting up an annuity plan.
Annuities are taxable in the same way that employment is. His Majesties Revenue and Customs (HMRC) class all income from annuities as 'earned income.'
The total amount of tax you pay will depend on the total amount of 'income' you receive throughout the year. This amount is then taxed in line with whichever tax band your income falls into.
Drawdown
A pension drawdown, sometimes referred to as a flexi-access drawdown (FAD), is another way of providing a regular income throughout retirement.
Pension drawdown allows you to take an initial 25% tax free lump sum from your pension pot, whilst investing the remaining funds. You can decide which funds you would like to invest in based on your objectives and the level of risk you are comfortable with.
As with all investments, the value can go up or down, and it is recommended that you have an annual review with a qualified financial adviser.
Drawdown pensions are taxed as ‘earned income’ meaning the annual amount of income you make from your investment will dictate the percentage of tax you pay.
Can I mix my pension options?
You can mix and match these options by using parts of your pension pot in different ways. If you’ve collected multiple pension pots throughout your career, you can use a different pot for each option.
For example, you can use part of your pot to purchase an annuity, and dip into the remaining pot by taking one-off cash lump sums. This could give you the security of a regular income and the freedom of boosting your cashflow when you need it the most. You could also take an adjustable income from your pension pot with a flexi-access drawdown, giving you flexibility and control over your hard-earned savings.
If you decide you don’t want to take all your pension straight away, you can take one of your pots as cash and leave the other as it is. This will give you a pot of cash that you can use as you wish, while potentially growing the other as it stays invested in funds, giving you a nice boost to your money when you choose to take it later in life.
Bear in mind, that not all pension providers offer all these options, so you should check what’s available to you with your provider. This isn’t always a straightforward process and deciding how you’ll take your pension isn’t something to take lightly, so it may be worth seeking professional advice from a Specialist Financial Adviser from Wesleyan Financial Services.
What should I consider when mixing my options?
This depends on which options you’re considering. If you only have one pension pot and you take it all in one go, you won’t be able to change your mind or consider other options, as you’ll have no savings left to collect.
If you decide to purchase an annuity, you won’t be able to change your mind later down the line, even if your circumstances change or you find a better deal. This is because annuities normally can’t be changed or cancelled once they’ve been set up.
You’ll also need to consider the tax implications of taking money from your pension pot. Regardless of which option you choose, you’re entitled to take up to a quarter of your pension pot tax-free. You can take this how you wish, either all at once as a cash lump sum, in several smaller cash sums, or through an annuity.
The remainder of your pot will be taxed as regular income, and you may be hit with emergency tax if you take more than the initial tax-free amount for the first time. If you do end up overpaying tax, you can claim this back directly from HMRC.
Tax is dependent on individual circumstances and can change in the future.
Can I still make contributions to my pension pot after I retire?
If you still want to contribute to your pension pot after you start drawing from it, you’ll need to be aware of the MPAA. The MPAA (Money Purchase Annual Allowance) is how much you can contribute to your pension and still receive tax relief. You’ll normally get tax relief on up to £60,000 of your contributions, but this threshold will go down to £10,000 if you take your money as:
- Ad-hoc lump sums or one lump sum of your whole pension pot
- Income from a flexi-access drawdown
- Income from an investment-linked or flexible annuity
If you’re considering one or more of these options, this may impact how much you want to add to your pension pot, or if you still wish to contribute at all.
The MPAA only affects defined contribution pensions, not defined benefit pensions.
Compare your pension options
If you decide you don't want to mix your options, you can always choose a single way to take your pension. We've put together a comparison table to give you an overview of the different ways you can take your pension:
| Annuities | Taking whole pot as cash | Cash lump sums | Drawdown | |
|---|---|---|---|---|
| Provides a regular income? | ||||
| Provides a secure income for life? | ||||
| Allows you to change your income? | ||||
| Is your remaining pot still invested? | ||||
| Affected by the stock market? | ||||
| Can it provide an income for a dependant? | ||||
| Can I take my pension from age 55? |
This table is an illustration of your possible pension options. The options available to you will depend on your individual circumstances, including the type of pension you have.
If you don’t want to take your pension straight away, you can choose to defer your pension benefits. Find out how deferring your pension works and what you’ll need to consider, in our guide to deferring your pension benefits.
Ultimately, everyone’s circumstances are different, and reviewing your pension options will be all about working out what’s right for you.