How Does a Pension Drawdown work?

Home Retirement How does pension drawdown work?

At a glance

There are no limits on how much you can withdraw from a contributory pension
Once you use pension drawdown the amount you can save into your pension is reduced
25% of your pension pot is available tax-free when using drawdown.

Once you decide to retire, you’ll need to figure out how to withdraw from your pension pot. While there is the option to purchase an annuity or make a lump sum withdrawal, taking your pension through a drawdown can be a viable alternative.

In this guide we’ve explained what a pension drawdown is and if it is better than an annuity.

What is a pension drawdown?

Otherwise known as a flexible retirement income, a pension drawdown lets you withdraw from your pot as you wish.

There aren’t any limits or restrictions to the amount you can withdraw from your fund, which might suit some people. However, this flexibility does mean you’ll actively need to monitor your pension so it doesn’t run dry.

All withdrawals contribute towards your taxable income, which is explained in more detail below.

How does a pension drawdown work?

A pension drawdown is only available to those aged 55 or older, and in 2028 this will increase to 57.

Since up to 25% of your pension can be withdrawn tax-free, you’ll have two options. Either you can withdraw a quarter of your pension pot as a one-off, tax-free, lump sum or you can keep 25% of each of your withdrawals tax-free.

The decision you make here could affect your tax liability in the future. If you decide to take your tax-free amount as a single lump-sum, all of your future withdrawals will count towards your income.

To explain, consider the example below.

One of Sandra’s pension pots stands at £250,000. She can withdraw £62,500 of this tax-free in a lump sum payment, leaving her with £187,500 liable for income tax. If she wants to withdraw £1,500 a month from this pot the entire amount will contribute towards her taxable income. Over a year her withdrawals will amount to £18,000, of which, assuming she has no other taxable income, £5,430 will be taxed.

Now, if she chose to earn 25% on each of her withdrawals her tax liability would look different. Just £13,500 would count towards her income, of which £930 would be liable for tax. However, she would not have that pot of tax-free money to draw upon when she wants.

When should I consider a pension drawdown?

If you’re only withdrawing what you need from your pension each month, the rest of your pension can continue to grow.

While this may seem like one of the main benefits of a pension drawdown, it can also be a disadvantage. If your pension is left in a heavily exposed fund, it could reduce your holdings.

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Can I continue to pay into a drawdown pension?

Yes, you can still make contributions into your pension if you opted for a drawdown.

For some, this is where things can seem more complicated as the Money Purchase Annual Allowance (MPAA) comes into play. In essence, once you take your first tax-free withdrawal from your pension the MPAA kicks in and you’ll be allowed to deposit £10,000 at most into your pension.

Any deposits over this threshold will be liable for tax upon withdrawal.

If this is something which affects you, then it is worth speaking to an independent financial adviser to determine whether your pension is the best place for your cash.

What charges can I expect?

The charges you’ll face depend on your pension provider.

However, we’ve listed some of the fees you could encounter, below:

Drawdown fee – This is charged on each withdrawal made from your pension. It could be a set charge or a percentage of the amount withdrawn.
Service charge – This usually comes in the form of an annual fee for holding your pension. Many providers charge a percentage of your pension holding.
Exit charges – If you wish to move one of your pension pots to another provider then you may face an exit charge.

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How does pension drawdown work?