Tax! The downside is that with each pension only 25% of the fund can be taken tax-free.
A person aged 55 is earning £20,000 per annum and paying about £1,800 in tax on those earnings. He has a pension fund worth £40,000 and he wants to take it all out. He would get the first £10,000 tax free. The remaining £30,000 would be added to his £20,000 other earnings and he would be taxed
as if he had earned £50,000. This would result in him paying £9,200 in tax instead of £1,800. So he would lose £7,400 of his £30,000 pension to the taxman. A person already earning enough to put him in the higher rate tax bracket (40% tax where the total income exceeds £43,000) could lose 40% of the money he takes out over and above the tax-free amount. In our example of a £40,000 pension fund, he would still get the £10,000 tax-free but lose £12,000 of the remaining £30,000 in tax). Therefore it is important to take tax into account when working out when to take money out of the pension.
(Note: this article refers to personal pensions only; the rules are different for a Final Salary Scheme where the benefit is based on the salary and years of service and some other special types of pensions.)
(Note: all these options assume that you take out the tax-free cash.)
Drawdown arrangement as it provides the flexibility for you to draw out whatever sums you want at any time you want them. But remember that once you have drawn out the tax-free element, any other monies you take out will be taxed. Such an arrangement also involves investing your pension fund so you would need to consider both the risk that comes with such investments as well as the provider’s charges for running the pension.
Option 2: Use the balance left over to set up a guaranteed income for life (an “annuity”). The amount of income received would depend on your age – the older you are, the more you would get. The amount of income you would get also depends on your state of health – the worse off you are health-wise, the greater the income you are likely to receive. You can set it up on just your life or so that it covers both you and your spouse/partner. The idea of guaranteed income is attractive but the current annuity rates are quite low so the amount of money you can obtain may be a bit disappointing.
Option 3: Take a short-term guaranteed income (a “temporary annuity”). This pays out a guaranteed level of income for a fixed number of years and then pays out a guaranteed sum on maturity – which can then be used again in Option 1 and 2 above or to repeat this Option 3 for a further term of years.