After reaching my 60th birthday last month I took the opportunity to crystallise my pension into drawdown, taking my 25% tax-free lump sum in the process. I’m now planning to start taking an income from the taxable part of my fund – is there anything I need to be aware of before I go ahead?

Kathryn

Tom Selby, AJ Bell Senior Analyst says:

While it would be impossible to cover everything you need to consider when entering drawdown in this column, here are some of the main things you need to think about.

Taking taxable income flexibly from your pension will trigger an irreversible £36,000 cut in your annual allowance. 

Taking even £1 of taxable income from your pension will trigger the money purchase annual allowance (MPAA), reducing the amount most people can save in a pension each year from £40,000 to just £4,000.

Furthermore, if you trigger the MPAA you will lose the ability to ‘carry forward’ unused pensions allowances from up to three previous tax years, meaning in some cases the impact will be a £156,000 reduction in the potential annual allowance in the current tax year, from £160,000 to £4,000.

To avoid an annual allowance cut, you could consider using money held in vehicles such as ISAs or cash savings accounts before touching your pension.

This can also make sense from an inheritance tax perspective as pensions can now be passed on to nominated beneficiaries
tax-free if you die before age 75, or at your beneficiaries’ marginal rate of tax when they take an income if you die after age 75.

Your first taxable withdrawal will be subject to emergency ‘Month 1’ taxation. 

When you first take taxable income from your pension, HMRC will automatically tax it on an emergency ‘Month 1’ basis. This means the usual tax allowances are divided by 12 and then applied to your first withdrawal.

For example, if you made a £12,500 taxable withdrawal in 2020/21 and had no other taxable income, you might expect to be charged 0% income tax as the withdrawal is within your personal allowance.

However, because it is your first taxable withdrawal only £1,042 (£12,500 personal allowance divided by 12) is taxed at 0%. The next £3,125 (£37,500 basic-rate tax band divided by 12) is taxed at 20%, with the remaining £8,333 taxed at 40%.

For those taking a regular income this shouldn’t be a problem, as any overpaid tax in the first month will be ironed out via your tax code. However, where it’s your only payment during the tax year there are two options – wait until the end of the tax year for HMRC to hopefully sort it out, or sort it out yourself by filling out one of three forms.

Once you’ve filled out and sent off the relevant form, HMRC says you should receive a refund of your overpaid tax within 30 days.

The link to the forms is available here. 

Beware big income withdrawals during falling markets. 

We are experiencing the first bear market – characterised by falls in stocks of more than 20% – since the pension freedoms launched five years ago. The coronavirus pandemic and global economic shutdown has brought into sharp focus the importance of understanding the investment risks you are taking and managing withdrawals sustainably.

This is particularly the case where large withdrawals come at the same time as big falls in markets, a phenomenon often referred to as ‘pound-cost ravaging’.

If you want to manage your withdrawals sustainably and avoid selling down your capital at a low point in the market you could use other cash resources – such as ISAs and cash savings – in order to keep your underlying pension intact.

Taking a natural income – meaning you simply live off the dividends your investments produce – has also been a good strategy previously, although finding companies paying dividends could be a bit like catching smoke in 2020.

If you do plan to make capital withdrawals from your pension, the key is to have a plan in place and review your income strategy regularly, ideally with the help of a regulated adviser, to ensure you aren’t risking running out of money early in retirement.

Are you happy with the risks you’re taking?

According to a 2018 market study by the Financial Conduct Authority the vast majority of people cite accessing their 25% tax-free cash as the main reason for entering drawdown. This is understandable given it is one of the main tax benefits of saving in a pension.

Although accessing your tax-free cash won’t necessarily mean a change in your underlying investments, it is worth using
this as an opportunity to review your retirement plans and ultimate goals.

For example, someone like you who is planning to take a regular income after accessing their tax-free cash will likely have a different asset allocation to someone who doesn’t plan to touch the remaining money for 15 years.

You also need to be aware of, and comfortable with, the risks you are taking. Although investments can go down in value as well as up (as we have seen in dramatic circumstances recently), the value of cash will be eaten away by inflation over time.

DO YOU HAVE A QUESTION ON RETIREMENT ISSUES?

Send an email to editorial@sharesmagazine.co.uk with the words ‘Retirement question’ in the subject line. We’ll do our best to respond in a future edition of Shares.

Please note, we only provide guidance and we do not provide financial advice. If you’re unsure please consult a suitably qualified financial adviser. We cannot comment on individual investment portfolios.

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