Tax benefits of Drip-feed Drawdown
Using the tax-free cash lump sum to supplement regular income payments can offer advantages over the more traditional option of taking it all at once.
Retirement Income and the importance of Tax-Free Cash
Traditionally, tax-free cash has been received as a lump sum at retirement and used to pay for things that might otherwise be unaffordable: paying off the mortgage, perhaps, or buying a dream holiday. This approach was often justified because tax-free cash was the only way to draw a large lump sum from a pension and being tax-free the timing of the payment in the tax year didn’t matter.
It’s now been over a decade since Pension Freedoms gave savers greater control over their retirement savings, allowing them to take all their benefits in one go from their normal minimum pension age (55 but increasing to 57 from April 2028) if they wish.
This increased flexibility means that tax-free cash is no longer the only way to receive a large payment from a pension, freeing it up to be used for other purposes. Many will still take their tax-free cash in one go, particularly if their earnings remain high at retirement and they want to avoid high rates of income tax, but others may be able to utilise the lump sum to increase the tax-efficiency of the withdrawals they receive from their pension pot.
Drip-feed Drawdown – Enabling a more flexible approach
Drip-feed Drawdown is automated functionality that can support you to help clients do this. The concept is straightforward: drawdown income and tax-free cash are taken together on a periodic basis (monthly, half-yearly etc.) with the flexibility to change the amounts they receive at any time. The tax-free cash component can be varied as a percentage of the total payment to tie in with the client’s requirements. As part of the payment is tax-free, the income tax liability will usually be lower than if the full amount was received as drawdown income.
Equally, as the payment is not solely comprised of tax-free cash (unless they use the 100% tax-free cash option) more is retained for the future, which will also increase in line with the investment growth the pension fund achieves.
Another benefit is that by paying less tax on withdrawals now – and particularly in the early years – more funds can remain invested and have a longer opportunity to produce further growth. This also fits in with a general principle of tax-planning: pay the lowest amount of tax you can using available allowances and tax bands.
Finally, although the full impact of the last Autumn Budget is not yet known, a result could be that we see more pensions accessed earlier to prevent them from forming part of a client’s inheritance tax bill. This means the automation available with Drip-feed, as well as the flexibility to vary payments to meet clients changing needs, will be beneficial to advisers to help cope with this potential increased activity and demand.
How Drip-feed Drawdown can help clients
The following examples show how Drip-feed Drawdown could be used to help different types of clients.
Example 1
Mitch
Aged 63
Needs to supplement his income.
Mitch, who has recently retired aged 63, receives an annual final salary pension of £8,570. He has £170,000 in a personal pension. To meet his needs, he requires £16,570 per annum and wants to draw from his personal pension for a few years until he takes on a part-time job to supplement his income.
He wants to make sure his personal allowance is not wasted so he requires some taxable income. An £8,000 withdrawal is made from his pension through Drip-feed Drawdown made up of £4,000 tax-free cash and £4,000 taxable income. The latter income plus his final salary pension of £8,570 use up all of his £12,570 personal allowance, meaning the full £16,570 can be received free of tax.
Drip-feed Drawdown has allowed Mitch to take just the right amount of taxable income to use up his personal allowance. To account for indexation to his final salary pension and possible continued freezing of tax bands, he can adjust the mix of income/cash whenever he needs to.
The above example demonstrates how someone can use Drip-feed Drawdown to maximise use of the personal allowance at retirement. It can also be used as people with higher income levels move more gradually into retirement.
Example 2
Debbie
Aged 60
Uses pension to make up shortfall.
Debbie is aged 60 with a salary of £60,000 per annum. She wants to partially retire, but working four days a week means her salary will reduce to £48,000. To maintain her standard of living she plans to access her personal pension fund of £600,000 to make up the £12,000 shortall.
This £12,000 income Debbie previously received, gave rise to £4,346 in tax (£2,270 taxed at 20% and £9,730 taxed at 40%) and generated a net income payment to her of £7,654.
Debbie wants to minimise her tax bill, so takes tax-free cash and just enough taxable income to avoid the start of the higher rate tax band (£50,271 and above).
Crystallising £24,000 per year via Drip-feed Drawdown will generate £6,000 of tax-free cash. She can then draw £2,000 as income which will be taxed at 20% (£2,000 at 20% = £400), giving rise to a total net payment of £7,600 (broadly the same as her net income before).
The above approach highlights that Drip-feed Drawdown isn’t just helpful for clients close to the basic rate tax threshold. It can also be used for those near the higher or additional rate tax thresholds, to ensure they remain tax efficient as they move gradually into retirement.
If this client’s needs change in the figure, regular payments can also be adjusted or stopped as required, to continue to match their income needs with their lifestyle.
These examples are for illustrative purposes only and use the income tax bands that apply to England, Wales and Northern Ireland.
How Scottish Widows can help
Scottish Widows Platform now offers Drip-feed Drawdown, which can help your clients take regular income from their pension in a more tax-efficient manner.
- Easy to use: Fully digital and built into our existing ‘crystallise pension benefits’ platform journey.
- Fully automated: Set up regular automated payments, helping save you time and manage clients more cost effectively.
- Future flexibility: Payments can be adjusted or stopped as required, giving you the flexibility to better match client’s income needs with their changing lifestyle.
Find out more about how this functionality can help you and your clients by visiting our Drip-feed Drawdown web page.
