Drawdown

What happens when you retire?

When you retire, you’ll (probably) have two accounts (a SIPP and an ISA) containing investments that you can sell whenever you like to give you money to live on.

With the ISA it’s that simple. Sell some units or shares, withdraw the money, get spending. There may be a settlement period of a day or two between pressing “sell” and being able to withdraw the money into your bank account.

With the SIPP, you have to have reached Pension Access Age. The government are tweaking this but it’s currently around age 58-59, and will probably continue to be ten years prior to your State Pension age.

Currently SIPPs are part of an outdated pensions system which gives the platforms various hoops to jump through. Expect to have to fill in an online questionnaire about your income needs, and to be offered a pension advice interview.

Pension drawdown income is taxable, although you get some nice allowances. The government expects the platform to deduct tax for them, much like an employer deducting PAYE tax from your wages. When you first make a drawdown, this may well have “emergency tax” taken off which you then have to reclaim (what a faff!). Perhaps by the time you reach this point the government will have fixed this clunky system.

The alternative to simply drawing down from your SIPP when you need income is to use some of your savings pot to buy an Annuity. Not many people do this now, even though it used to be the only method. This is because the rates on offer are usually quite a bit worse than you can hope to get by leaving your money invested and drawing down as you go.

Tax free lump sums

Here the system is again very confusing!

In essence, you are allowed to take up to 25% of your pension pot as a taxfree lump sum. You can do this at the start of your retirement in one big lump, you can take repeated smaller lumps, or you can have 25% of each withdrawal taxfree before the rest falls under “income” for income tax purposes.

These two methods are labelled with sets of confusing acronyms which don’t describe what they do very well. (“UFPLS and FAD”!) If anyone in government is reading this, maybe you could sort it out please?

Almost every bit of pension literature you read will go with the assumption that you’ll withdraw your 25% immediately and go and splurge it on a new motorhome or something similarly stupid. This is pretty unhelpful when you consider that almost all savers are on track to fall short of saving their retirement needs.

If you don’t need the cash now, I’d be tempted to leave it where it is. Either take the 25% taxfree with each withdrawal to pay less tax each year, or perhaps take lump sums each year so that you can put the taxfree lump into your ISA where it can remain invested and growing.

Tax Optimising in Retirement

Pension money counts as “income” and attracts income tax. Boo! Okay, there are some tax breaks - 25% of any drawdown is tax-free, and then you have the tax-free Personal Allowance to use up each year before income tax becomes due. This is currently £12,570. This means that you could draw about £17,000 from your personal pension before paying any income tax. Pretty good. And this system is kind of fair if you consider that you were allowed to defer paying tax on your income back when you earned it and put it into the pension, on the basis that some of it would be taxable later on.

When your State Pensions kicks in, it also helps use up your Personal Allowance. So for the optimisers among us, your goal in retirement will be to burn up your personal pension money as quickly as possible while staying under the income tax wire, shunting what you can into your ISA, before your State Pension comes along and uses up all your allowances.

Then your state pension can fund your basic living while your ISA provides you with more luxury living, without paying any tax. If you needed more income than this, you’d look to your remaining SIPP but mostly on a taxable basis.

This sort of planning is far down the road, and all the governments in between are likely to move the goalposts!

I mentioned above the idea of drawing enough taxfree lump each year to fill your ISA allowance. Some people like to do this in case future governments ever move the goalposts on the taxfree lump sums, thinking that money already in an ISA may be safer from political interference.

If you have saved more than you could get into your tax sheltered accounts and have additional money invested in a GIA, you get some taxfree allowances in there too. I’ll write a separate article about GIA investing which will cover that.

 

 That's the end of my FIRE basics series. Back to home?