As more people mix pension income with earned income, phased drawdown is growing in importance
There is no doubt the nature of retirement is changing. People are increasingly considering different ways to transition to it from full-time work, with many choosing part-time work or a consultancy career.
This is being driven by several factors: the relative wealth of the now-retiring baby-boomer generation, rises in the state pension age, the introduction of pension freedoms and better health later in life, to name a few.
However, some people are reluctant or unable to settle for a smaller salary, and there is a growing desire to use pension flexibility to top up incomes to
make sure they can keep up with their lifestyles.
Phased drawdown is an ideal way of achieving this. By taking a small segment of their pension savings, someone can receive tax-free cash and taxable income.
They can use part of the taxable drawdown income to top up any earned income up to the personal allowance, avoiding paying income tax, and then use the tax-free element to boost their income further still.
Arisha has recently retired from work and taken on a consultancy role paying £9,000 a year. She wants to use her pension plan worth £300,000 to top up her income to £20,000 a year, and she would like to do this as tax-efficiently as possible.
She crystallises £30,000 from her pension fund in 2019/20, releasing £7,500 of tax-free cash. Any income she takes from the remaining £22,500 will be taxable.
She can use £3,500 of her taxed income to add to her earned income of £9,000, to give her an income of £12,500, the same as the personal allowance.
She can then use £7,500 tax-free cash to top up to her desired income of £20,000. And she pays no tax.
As she has only taken £3,500 of drawdown income, the remaining £19,000 remains invested in her drawdown plan.
The table below shows what would happen if Arisha continued to phase her pension plan over 10 years.
By taking a taxable income from her drawdown fund, Arisha will have triggered the money purchase annual allowance, and if she chooses to contribute to her pension, she will be restricted to the £4,000 allowance.
After 10 years, Arisha would have an accumulation pension plan worth £16,666 and a drawdown fund worth £237,352, giving a total of £254,018.
She can then start to take a larger income from her drawdown fund as she stops working.
Taking Arisha’s case a step further, using automated phasing can set up a monthly income that most people expect with minimal intervention from the adviser or planner firm.
For example, the table shows that in the 2021/22 tax year, Arisha would like to crystallise £31,212 and this could be paid as 12 monthly automated phases.
Each month, she will crystallise £2,601 from her pension plan, taking £650 tax-free cash and £303 in drawdown income.
This, together with her earned income of £780, gives her a total monthly income of £1,734.
As more people mix pension income with earned income, phased drawdown is growing in relevance and importance. The pension rules offer full flexibility, so it makes sense the options offered by the pension scheme match this – in particular, giving clients the ability to set the drawdown income they take out of the pension at the most suitable level, regardless of the pension commencement lump sum
By using this flexibility, advisers and planners can work with clients to set up the most tax-efficient pension income stream to suit them.
Rachel Vahey is product technical manager at Nucleus