10 things to know about accessing your pension

Pension freedoms are great, but can lead to confusion, bad decisions and expensive mistakes. Faith Glasgow runs through the main things to bear in mind when you want to get your hands on your pension pot.

After decades of building up a pension, it can feel quite daunting - the start of a new chapter of life, perhaps – to actually draw money out of it. But drawing a pension is no longer synonymous with a sedentary retirement: many older people these days continue to work while supplementing their earnings with pension money, for example.

Since 2015, when pension freedoms were introduced by then chancellor George Osborne, the choices around funding your retirement have broadened dramatically. Choice is good, but it can also easily lead to confusion, bad decisions and expensive mistakes.

To help you keep abreast of the considerations that could be relevant to you as you think about accessing your pension, here are 10 things to bear in mind.

1) You can access your pension from age 55

Although you won’t be able to claim your state pension until your mid to late 60s (depending on when you were born), you may well be able to start taking money from your workplace or personal pension much earlier.

The youngest you can normally access a workplace or personal pension is age 55, although this minimum age is set to rise to 57 by 2028 and then remain 10 years below state pension age. Defined benefit pension access ages vary according to the scheme.

Remember that the younger you start drawing from your pension, the longer you could potentially have to make that money last. Becky O’Connor, head of pensions and savings at interactive investor, says: “The difficulty, of course, is not knowing how long you are going to live for, or what unexpected costs you might still incur as you get older.”

• Think before dipping into your pension
• 22 little-known pension tips and tricks

2) Tax-free cash

You can take up to 25% of your pension pot as tax-free cash. This is a big plus anyway, but it’s particularly useful if you want to continue working and contributing to your pension at the same time.

So long as you limit your withdrawals to tax-free lump sums and don’t draw any taxable income from your pension pot, you are free to carry on building it, up to the £40,000 annual contribution ceiling.

That could be invaluable if, for instance, you’ve fallen back on your pension to see you through a period out of work but then you start a new job, because it means you’ll be able to take unrestricted advantage of the pension benefits on offer, including employer contributions.

O’Connor says: “There are all sorts of reasons someone aged 55 or older might want to use their lump sum besides wanting to retire there and then. More and more people are continuing to do some form of work well into their 60s and might be well able to make decent pension contributions from this income, too.”

However, if you touch the taxable element of the pension pot, you’ll automatically trigger what’s known as the money purchase annual allowance (MPAA), which means your annual contribution allowance is slashed to just £4,000 a year. (The MPAA applies to defined contribution pensions only.)

There are different ways to access your tax-free cash, as we see below.

• Don't be shy, ask ii…am I saving enough for a decent retirement?
• Be frugal at 40 and prioritise your pension

3)  Different ways to take a pension income: annuities

There are three main ways you can use your pension pot to produce an income, and they are not mutually exclusive. The first is to use the money, or some of it, to buy an annuity that will pay a guaranteed income for life.

You can take up to 25% as a tax-free lump sum before you do so; the annuity income itself is taxable in the usual way.

The good thing about this route is the financial security it provides.

The bad things are, first, that annuity rates remain at historic lows, although they have improved notably from the rock-bottom rates seen in 2020. As of March 2022, a 65-year-old buying a level (not inflation-linked) single life annuity for £100,000 can get around £5,320 a year.

The second drawback is the lack of flexibility. Buying an annuity is irreversible; moreover, because an annuity ‘dies’ when you do (unless you’ve bought a joint annuity that covers your spouse as well), it can’t be passed on to family members even if you die.

Annuities do become increasingly attractive with age, however. Not only is it likely that security will become more appealing, but annuity rates are calculated on the basis of life expectancy and therefore rise automatically with age. You may qualify for an enhanced annuity paying even higher rates if you develop health issues.

Rising interest rates will also boost the rates on offer, and may add to annuities’ relative appeal, especially if stock market returns are being undermined by low growth and inflation (stagflation).

“A good-value annuity is in some ways the ideal form of retirement income, because you don’t have to think about it, you just get paid,” says O’Connor. “It’s likely that as rates improve, they will become more popular again, but for now, people continue to be disappointed to find what their pension pots are worth as an annuity income.”

• How to invest...for an early retirement
• Top 10 jobs for pensions

4) Income drawdown

A second way to take an income from your pension is to keep it invested in the market but move it into a drawdown account either with your current pension provider (if it offers drawdown) or with a separate platform such as ii, from where you can set up regular payments or take occasional lump sums.

You don’t have to move the whole pension into drawdown at once (or at all), but you can take up to 25% of whatever you move as tax-free cash without triggering the MPAA (see above). The other 75% will be taxed as normal income as and when you withdraw it, and it’s only at that point that the MPAA kicks in.

One of the difficult things for many investors to work out is how much income they can afford to take in order for their pension to last as long as they do. This will depend on various factors, including the state of the stock markets, their appetite for risk, and whether they want to leave some pension as an inheritance; but as a broad rule of thumb, experts say drawing around 4% of your pension value each year is sustainable.

The other big question is how best to invest the money to meet your requirements. This is one occasion when it’s well worth paying for independent financial advice, or at least speaking to the free government guidance service, Pension Wise.

If you don’t, and are unsure how to reinvest your pot for income, drawdown providers including interactive investor provide simple, low-cost Investment Pathways as investment suggestions, according to how and when you want to use your pension pot.

• Pensions: is 12% the new 8%?
• ‘Pension Builder’ launched by interactive investor

5) Lump sums

The third option for income is to take occasional lump sums direct from your invested pension. It’s known in pension jargon as UFPLS, which stands for uncrystallised fund pension lump sum.

The key difference between taking lump sums and drawdown is that each lump sum includes 25% of tax-free cash and 75% of taxable income; the rest remains invested in your pension. In this case, your MPAA is triggered by the first lump sum you take.

• Pensions Unpacked: are people getting big enough retirement pots?
• Pensions versus ISAs: a beginner’s guide

6) Emergency tax code

When your pension provider has not yet received your tax code from HMRC, it will apply a temporary, ‘emergency’ tax code when you first withdraw a taxable lump sum. The trouble is that these tax codes - ending M1 – treat that sum as the amount you’re going to withdraw every single month for the remainder of the tax year. It could mean that you pay more tax than necessary when you first start withdrawing your pension.

Don’t worry because HMRC will automatically send your pension provider the correct tax code in due course, and any overpayment will be sorted out. In most cases HMRC will provide an amended tax code so any overpayment can be gradually corrected.

• Pension tax relief: the secret weapon to combat inflation
• Pension stories: examine the saving habits and goals of investors at different life stages

7) Withdrawing cash without cause

One scenario that has caused concern among experts is the risk of people using their pension freedom to withdraw large lump sums or cash in their whole pension, but then simply banking the cash, perhaps because they feel nervous about stock market investments.

Consultancy LCP calculated in 2021 that around £2 billion may have been lost since pension freedoms were introduced in 2015, as a result of around 1.7 million people doing just that.

The FCA itself did research in 2017 into what they did with the money, and found that a third put the majority into an ISA or bank account “to either drawdown or keep as a safety net”. Most of these were cash accounts rather than investment ISAs.

The problem is that they miss out on potential earnings. Interest rates remain at rock-bottom, whereas the FCA data shows that a mixed-asset pension would earn around 4.4% a year. Critically, their money is also losing real purchasing power as it trails behind inflation. And there may be tax implications, as we saw above.

“The message is that unless you have a plan for your cash, it makes more sense to leave it within the tax-free growth environment of the pension wrapper until you need it,” says O’Connor.

• What is a SIPP?
• Visit our Pensions and Retirement Hub

8) Small pots

There are special rules for cashing in pension pots worth less than £10,000, known as small pot or trivial commutation rules. You can cash in up to three personal pensions from different providers, or any number of workplace pensions (but check with the scheme providers).

You’ll pay tax in the usual way on 75% of the lump sum with 25% tax-free, but there are other benefits. First, you can cash them in without being penalised if they exceed the Lifetime Allowance. Also, they don’t trigger the MPAA, so they represent a way to access some pension capital while you’re still employed, without having to curtail your pension contributions.

• Your pension: think about it earlier and more often
• Pensions Unpacked: tax, allowances and reliefs

9) Consolidate your pensions

Most adults have multiple pension pots, which can lead to confusion and a risk of losing track of retirement savings. According to the interactive investor Great British Retirement Survey, two thirds of non-retired respondents had more than one pension pot, and 15% of these had four or more.

“Six per cent of non-retired respondents did not even know how many pension pots they had, highlighting a significant risk that they could lose track of parts of their retirement income,” adds O’Connor.

It therefore generally makes sense to bring old pensions together into one place, ideally a low-cost pension hub such as that offered by interactive investor. You may well reduce the charges you’re paying on older pots, and you’ll get a clear overview of the amount of money you have to invest and take an income from.

• ii Top 10...things to keep in mind when managing your own SIPP
• Don’t be shy, ask ii…how do I value my final salary pension schemes?

10) Pension inheritance rules

Defined contribution pensions (which covers all personal pensions and most workplace pensions) are a godsend if you’re worrying about inheritance tax, because they do not count as part of your estate. In other words, you can bequeath whatever money is left in your pension pot to your family very tax-efficiently.

Your pension is generally set up as a separate discretionary trust and therefore not covered by your will, so you need to provide an ‘expression of wish’ form to the scheme administrator to tell them who you would like the benefits to be paid to. It’s important to keep this up to date if your circumstances change.

Any tax on pensions after death is payable by the person inheriting. If you die younger than age 75, whoever inherits your pension has no tax to pay, provided the pension is cashed in or moved into a new account (depending on whether they want to take the money as cash or pension income) within two years. If you die aged 75 or older, the beneficiaries pay tax on any income they receive at their highest rate of income tax.

As a result it may make sense, if you have other income-producing investments that will count as part of your estate – ISAs, for instance – to use them first and leave your pension intact as long as possible, thereby reducing what’s liable to IHT and conserving what isn’t.

Annuities offer much less flexibility when you die, as mentioned above, although payouts may continue if you bought a joint contract or a guaranteed annuity that will continue to pay until the end of the guarantee period.

If you’re in a final salary type scheme, the rules of the scheme will detail which family members can benefit from the pension when you die.

• Top 10 things you need to know about your state pension
• ii SIPP customer stories