Your pension options explained - your handy guide

If you think talking about pensions isn’t exactly the most exciting topic in the world, we’re here to change your mind!

Pensions don’t have to be dull. But they can be a little daunting. And it’s hard to think about what could be far into the future. Especially when there are so many different pension choices to make. Like what to do when you’re ready to start taking money from it.

You can use this guide to give you helpful tips about how to access your pension, but it isn’t personal advice.

What type of pension do you have?

If you’ve got a pension where the amount you get at retirement depends on how much you pay in, you’ll have a ‘defined contribution’ or ‘money purchase’ pension.

These pensions are now the most common workplace pensions in the UK. If you've taken out a pension yourself – like a personal pension or a self-invested pension (called a SIPP) - it will also be a defined contribution pension.

Another pension that may be available through your workplace is a ‘defined benefit’ pension. These pensions promise specified benefits at retirement – usually an income for life based on the salary you had received.

It’s always worth double checking with your workplace pension provider to make sure you know what type you’ve got.

Pension options: the basics

The most basic rule that applies to pensions is that you usually can’t access your pension until you’re 55 (rising to 57 in 2028). And you don’t have to stop work to access your pension.

If you’re at least 55 - and you have a defined contribution pension – you have several options about how you access your pension pot.

This guide will help you understand what your options are and tell you about the pros and cons of each. This can help you to make an informed decision on what’s best for you.

• Option 1: You could leave your pension invested if you don’t need it yet and your money could continue to grow in the meantime.
• Option 2: Take your pension savings as a lump sum. This will be taxed at your marginal tax rate. 25% will be tax free and the remainder will be taxed at your marginal tax rate.
• Option 3: Take a flexible income from your pension. This is known as income drawdown. You can take up to 25% of your whole pension pot tax-free, either in one go or as smaller lump sums. The rest of your pension will be taxed as income at your marginal tax rate and can be taken in the future, as and when it’s needed.
• Option 4: Convert some or all of it into a guaranteed income for life by buying something called an annuity.

The good thing is you don’t have to pick one option over another. Unless you take your whole pension as a lump sum, you can mix and match and decide which options work for you.

Now let’s take a look at each option in more detail.

Option one: leave your pension where it is

Because you can choose when to access your pension pot, you can also choose to leave it where it is until you need it.

And while it’s untouched, there’s no tax to pay.

The real benefit of this is that your pension should continue to grow – tax free. Of course, the return on your pension isn’t guaranteed. But if you leave it untouched, it should hopefully be worth more over the years.

If you do decide to leave your pension where it is, it’s worth double checking where your money’s invested. If most of it’s in company shares, you may find that it yo-yos if the stock market has some ups and downs.

You may choose to take less risk with your investments as you get older – and you should be able to switch your pension to other lower risk investments. If you’re not sure how to go about this, talk to your pension provider or you can pay for advice from an independent financial adviser.

You might also want to check how much your pension and investment provider is charging you to look after your pension. If charges are high, this will eat into any returns.

Option two: Cash in your pension in one go

Take the whole amount as cash in one go and get up to 25% of this tax-free.

This might seem like a great way of taking control of your money. But there are some downsides. For a start, only the first 25% of your pension is tax free – you’ll be taxed on the rest.

So, if you have a pension pot of £80,000 and cash it all in, the first £20,000 will be tax free – but you’ll pay income tax on the other £60,000 at your marginal rate of tax. There is the potential for those pension monies to tip your income into a higher income tax band, depending on your personal circumstances. This means you might end up paying more tax overall with this option, rather than if the withdrawals were spread out over multiple years.

If you decide to access your pension, you’ll have to decide what to do with the money. And how you plan to fund your retirement if you withdraw fully. If you put your pension money in a savings account, the interest rate may be lower than inflation – and that means your cash will be losing real value when compared to the cost of goods and services. That means you might not be able to buy as much in the future with your money as you can now.

Option three: Take a flexible income

With this option, you can take a regular income from your pension pot, whilst it remains invested. With income drawdown, 25% of your pension pot is tax-free and the rest is treated as taxable income, but you're free to choose how much of the tax-free and the taxable amounts you withdraw and when in the future.

You can pay yourself monthly, quarterly, or annually – or even just as a one-off. And you can vary the amounts you take too.

Any money you don’t take remains invested to grow, including reinvesting any income. So, you could choose to take out only the income your fund generates and leave the rest to grow (but you’d usually need a pretty big pension fund to do this).

Income drawdown does have some disadvantages though. For a start, the charges can vary widely between different providers. This could include an annual charge, and a charge when you take money out.

There’s also a risk that you could outlast your pension, but any money left over would be passed on to beneficiaries. This is true for any option you choose other than buying an annuity from a provider.

Not all pensions are set up for income drawdown, so double check with your pension provider first. If it doesn’t provide the option, you may want to transfer your pension to a provide that does.

Option four: Buy an annuity

Converting some, or all, of your pension fund into an annuity has a different kind of advantage. You’ll get a set income for the rest of your life – no matter how long you live.

Buying an annuity means you hand over your pension fund to an annuity provider. The amount you’ll get depends on the type of annuity you choose, and the provider’s assumptions about how long you’ll live.

There are lots of different types of annuities. You can buy one that’ll pay you an income that rises at an agreed level and may include payment of an income to your partner or spouse after you die.

If you buy an annuity, make sure you shop around first. People tend to buy their annuity from the provider they’ve saved with. But you don’t have to do this – and you could get a higher income for life by going elsewhere.

One other thing to keep in mind is that, unlike with drawdown, whatever’s left within your annuity when you die can’t be passed onto your dependents. If this is something that’s important to you, have a think about whether having part of your pension in an annuity (rather than all of it) works better for you and your personal circumstances.

Passing on your pension

It’s never nice to think about what’ll happen after you die. But it’s really important to do it. Apart from what you’ve used to buy an annuity, whatever is left in your pension pot can be passed on.

If you’re under 75 when you die, and if you haven’t taken money out of your pension pot, your beneficiaries won’t have to pay income tax on it. The only exception is if your beneficiaries are paid more than two years after your pension providers are told of your death.

If you’re 75 or over when you die, your beneficiaries would have to pay income tax at their marginal tax rate (this is their highest personal rate). So, if your beneficiaries are normally basic rate taxpayers, but getting a payment from your pension puts them into a higher tax rate, they’d have to pay income tax on the money they received up to 45% on the value over the basic rate allowance. Although some providers offer an inherited drawdown service meaning beneficiaries don’t need to take all the money in one go and can take it out as and when they want.

Any money you’ve taken out of your pension but haven’t spent would be treated as part of your estate on death. That means there might be inheritance tax to pay. There’s no inheritance tax payable on any money remaining in your pension when you die.

Where to find out more

Your pension provider can give you information on your pension options. You can also get some free help from the government-funded service, Pension Wise at MoneyHelper. Find out more at MoneyHelper.org or give them a ring on 0800 138 3944.

If you ‘re not sure if something is right for you, you can find independent advice through Unbiased Link opens in a new window.