Phased Income Drawdown

In the past, almost everyone worked into their 60s, then retired completely and lived off their pension. These days, many people prefer partial retirement, reducing their hours at work gradually, over several years.

If you’re planning to retire this way, and you intend to fund your lifestyle through a combination of employment income and pension income, you’ll need to look at the most tax-efficient way to do this. In many cases, this will be through phased income drawdown, an approach we’ll explain here.

What is phased income drawdown?

Phased income drawdown is one way of withdrawing from a defined contribution (DC) pension – also known as a money purchase scheme – for people who have reached minimum pension age (this is currently 55 but increasing to 57 in April 2028).

It’s designed primarily for people who will continue to earn money from employment in the early years of their retirement although this is not it’s only application.

What are the benefits?

There are three main reasons you might choose phased income drawdown:

You want to allow your tax-free cash to grow

People who are retiring completely tend to move their whole pension into drawdown, take a standard 25% tax-free lump sum, and set up a regular taxable income from the remaining 75%. But if you’re continuing to work, you may not need all your tax-free cash now.

In this case, you may be better off leaving most of it invested, so it has the chance to continue growing. Investment growth isn’t guaranteed (and your investments can also fall in value) but it is typically more likely to grow in value the longer it is able to remain invested.

You want to pay less income tax on your pension withdrawals

Since you still have a regular income from your work, you may only need a little extra cash, and you won’t want to deplete your pension pot too much in these early years. If you can get by without withdrawing anything from the taxable portion now, you might pay less tax when you do.

For example, if you’re earning more at work each year than £12,570 (i.e. the personal allowance), any taxable pension withdrawals you make will be subject to income tax of at least 20%.

Whereas, if you wait until you no longer have that salary before taking taxable income from your pension, the first £12,570 you withdraw each year will fall within your personal allowance and be paid to you tax-free.

You want to continue to contribute to your pension

Finally, once you start to take an income from the taxable portion of your pension, you’ll trigger the money purchase annual allowance (MPAA). From this point on, you can only contribute up to £4,000 to your pension (including tax relief) in any tax year.

Since you’re still working, you might want to contribute more than this, especially if your employer matches your contributions. So, you might choose to only make withdrawals from your tax-free lump sum, which would allow you to keep up your contributions.

Potential downsides

There are a few drawbacks to consider, such as:

• Your pension value can fall as well as rise. If your pension value falls over time, you’ll get less tax-free cash by withdrawing in stages than if you withdrew it all at the start.
• Money you’ve withdrawn from your pension can be passed on without income tax, though inheritance tax may apply if your estate is larger than £325,000.
• Giving your pension more time to grow increases the likelihood that you’ll reach the standard Lifetime Allowance (£1,073,100 at the time of writing). If you exceed this, you’ll pay lifetime allowance tax charges on the excess depending on how your income is taken.

How it’s calculated

Phased drawdown calculations are complex, and they involve figures that will change unpredictably over time (i.e. your pension value can go up or down, and that means that the available tax-free cash changes too). We believe that it is beneficial to work with an pensions expert with access to a professional-level phased drawdown calculator to help you understand this option.

A phased drawdown example

For the purposes of explanation, let’s keep the calculations simple and say that your pension pot is worth £400,000:

If you were to retire and move your whole pot into drawdown at once, you’d be entitled to take £100,000 as a tax-free lump sum. You could establish a regular income from the taxable portion (£300,000)

With phased drawdown, if you wanted to reduce your hours at work and needed your pension to cover a salary reduction of, say £400 per month. You could take portions from your pension of £1,600 with £400 taken as tax free cash and keep the remaining £1,200 in a crystallised account.

As long as you only withdraw your tax-free cash, you can continue to contribute to your pension up to your annual allowance. Perhaps you contribute £250 a month, which – if you’re a higher rate taxpayer – achieves £5,000 annually. However, because tax relief only accounts for 20% – equivalent to £3,750 – (so, half of your nominal rate of tax), you would need to claim the remaining 20% relief back via self -assessment.

Let’s say your pension also grows by 5% per year. It will take around two years to reach a value of £400,000 again.

In the next phase, you might draw down another 10% of your pot (i.e. £40,000) and take £10,000 as a tax-free lump sum. You’ll continue making pension contributions and, for ease, we’ll say that your pension growth remains the same over the next two years.

Now:

• You’ve moved £80,000 into drawdown
• You’ve withdrawn £20,000 of this tax-free
• The taxable portion not withdrawn has theoretically grown to around £65,000
• You have around £400,000 still to draw down
• You can take £100,000 of that as a tax-free lump sum

We’ve used these figures to help to show the potential advantages of this style of withdrawal. In reality, they may look very different. Your pension value could fall instead of rise, and the amount of tax-free cash available could be less in total than if you had taken it as a lump sum at the start.

How to access phased income drawdown

There are several things you’ll need to do before starting to take an income this way.

Alternatives to consider

There are two main alternatives that also give you access to tax-free cash and allow you to flexibly withdraw an income from your pension pot:

Get matched with a drawdown specialist

Without knowing the details of your financial situation, it’s impossible to say whether you’d benefit from phased income drawdown or whether there’s another option that’s better suited to you. If you’d like to find out, we can put you in touch with a drawdown specialist.

First, we’ll ask you to provide us with some basic information, and then we’ll use that to match you with the advisor we think is best placed to answer your questions. To get started call 0808 189 0463 or fill out this form.