Costs when moving to income drawdown

GhIFA

Sam, with secured income in excess of £20k you are then free to withdraw from the remaining pension fund however you want, so yes, you could take it all in one lump sum - bear in mind however, that anything in excess of the remaining tax free cash will be taxable.

jamesd

Thanks for explaining the state pension. That's the highest I've seen yet, courtesy in part of you deferring, I'm sure!

Yes, when you have met the requirements and opted for flexible drawdown you really can draw out every penny of the pension pot at once if you want to. You wouldn't want to normally because only the 25% tax free cash is free of tax. As usual for pension income the remaining amount you take is added to your other income and taxed as usual, so you'd end up with higher rate or top rate tax on much of it.

But what you can do is keep all of your other money in an ISA and draw on the pension to fully use your basic rate tax band, regardless of how much you spend. No need to even consider the GAD limit because it'll no longer apply to you in flexible drawdown.

If you want income above the level where higher rate tax applies you can choose between getting the money out of the pension or using money that's already outside it, either from the tax free lump sum or any savings and investments.

Looking at potential income I see:

£315k of SIPP, reduce to 236,250 by taking £78,750 lump sum. Then at say 6% of capital for income (not necessarily sustainable indefinitely, but using it instead of 5% or 4% because of your age) the £236,250 might generate £14,175 income, taxable.
£200k of other savings and investments plus the £78,750 lump sum is £278,750 which at 5% (to avoid draining the tax free income potential) can generate £13,973 of tax free income. Income fund in an ISA to compensate for lower interest elsewhere, perhaps.

Looking at the income tax and income levels I see then you might have for 2013-14:

£15,780.48 state pensions (1315.04 a month)
£7,800 renewal commission
£17,869.52 taxable from pension, get to higher rate threshold £41450

---

£41,450 taxable
£35,048 after tax

£13,973 tax free

Total income after tax of £49,021.

That's drawing money from the pension at above the 6%/£14,175 rate to avoid draining the capital outside the pension. To compensate for that you should really drop the drawing rate on the money outside the pension by at least 17,869-14,175 = £3,694 to get a more sustainable income level, taking you to £45,327 plus your wife's income.

However, it's fine to deliberately plan to draw down the capital so long as you plan to not run out of money before you're say 100-110 years old, assuming a long life and nothing wrong physically that might prevent you from getting there.

You seem to be short of the £20,000 flexible drawdown figure by £4,219.52. At age 72 and with say a 2.5% gilt yield the GAD limit at 120% allows taking of 8.52% of the pension pot value. That's £20,128.50 from £236,250 so you don't need flexible drawdown to get to the top of the basic rate income band while you're still getting the renewal commission because that only requires taking £17.869.52. You will probably need flexible drawdown to cover for the lost renewal commission.

Since the £20,000 requirement for flexible drawdown is only adjusted periodically and the next adjustment is in a couple of years that implies that it's best to wait a year or two before buying a level annuity to get to the £20,000 because inflation-linked increases in state pensions will get you closer and reduce the amount of capital you need to spend on an annuity.

I haven't tried to calculate a sustainable income level for whatever life expectancy you have, rather I've concentrated on moving the money out of the pension to maximise flexibility. You shouldn't really be taking an after tax income of £49,021 after the renewal commission starts without checking the longer term implications and ensuring you won't run out of money. At the moment I'm making an assumption that at relatively young ages you want to be maximising ability to travel while you're most able to enjoy it and will accept some reduction in income level later. And also that for long term tax planning you want to maximise the amount in the ISA wrapper, assuming that income tax rates may rise in the future.

If you do want more than £49,021 then you can take some pension income taxed at higher rate or can draw on capital outside the pension, as you choose. But do take care because this will be an income level that is definitely not sustainable long term. However, you've indicated a need for around £40,000 of income including your wife's income so this shouldn't be needed.

Instead, taking up to the top of the basic rate band from the pension income will let you gradually move money from the pension to outside the pension, into the ISA tax wrapper, though it'll take a few years of using both of your allowances to get it all there after taking the tax free cash.

The critical pieces missing from these numbers are working out your anticipated life expectancy and calculating your sustainable income level. For a reduced risk level it'd also be prudent to cut your total spending level to use no more than 4% of total capital each year, unless you do deliberately want to accept the chance of capital value reduction. Not wrong to accept that reduction but if you do want to avoid it, 4% is a fairly cautious level to use to give a good chance of that.

SeniorSam

Thanks again James. You knowledge is top drawer and this forum is lucky top have you contributing to help so many people seeking guidance.

The fact that I did deffer my state pension and built up additional state benefits in the past has enabled me to have what I consider a really good pension from the State. With the addition of the small occupational pension of £1031.76 p.a. I could reach that £20k pension without too much difficulty if I wanted to go into the flexible route.

As mentioned, the renewal commission will not go on too long and I need to prepare for that 'drop off'. I have been thinking about the £30k in premium bonds that don't do very much at all and had been considering moving that to S&S ISA's. Originally the PB's were for the IHT need, but the Loan Trust has grown to £65k, which should meet the IHT need.

With my wife's state pension of £7466 pa she has ISA's but not so much capital and is at present a non tax payer. This may help in using some assets to give to her to generate income at the lower level of taxation.

As you say, working out life expectancy is always a problem. However, I believe that we can sustain a good level of holidays for the next few years, whilst we are bot fit and our health is not too bad, nothing that would be considered life threatening, although I have asthma, it is easily controlled.

I think we would all like to get the best out of the money we have saved, either as capital investment or as pensions. Nobody likes paying more tax than necessary and certainly nobody want to loose the pension by early death. IN any event, the children (2) could always finish up with a £500k house if all the money is gone.

All your info is being carefully considered and I may well come back with a few more questions.

Thank you once again.

Sam

jamesd

It's not purely financial planning but given your situation I urge you to look to spend £55,000 to £60,000 a year for the next five to ten years on things like life plus travel that you might not be able to do later in life. If there are things to do which you would enjoy that cost that much.

Here's a rough calculation method that lets you get some somewhat reasonable idea of the spending now vs spending later trade off.

Assume 3% of investment value as income, using 3% of 80% of the residual pension pot after taking the lump sum to allow for basic rate tax. At that level of income you are quite unlikely to see a drop in capital value. That gets you to long term income of:

£5,670 = 236250 * 0.8 * 0.03 the 75% pension
£14,512 = 15780 state pension, using personal allowance and some 20% tax
£825 = occupational pension after basic rate tax
£7,466 = wife's pension, no tax due
£8,347 = 278250 invested tax free taking just 3% income

Total of £35,995 of after tax income for both of you, with high chance that this would last for life and leave all of the capital inheritable.

Now assume you live to be 110 years old. That's 38 years away.

Say you want to spend £60,000 for five years. You then have to pay for that (£60,000 - £35,995) * 5 years = £120,025 over the remaining 33 years. That drops the income for those years from £35,995 to £35,995 - (£170,025 / 33) = £32,357.

That sort of future income five years out would almost certainly be fine, but if not, cut back to £55,000 instead of £60,000 or do £55,000 for ten years instead of £65,000 for five years... play as you like. Do not let the five years extra cost go much above £120,000 or the ten year cost go much above £160,000 - those are the upper limits for which the approximation makes reasonable sense. These costs are the £120,025 part of the calculation I gave - how much capital you might drain while taking the higher income, if the investment income isn't higher than the assumption used.

If there is a big market drop while taking the higher income from capital, decrease the amount of income taken until markets recover. Or accept lower later income.

It's drawing on capital initially and that increases the actual cost a bit - do it for more or longer and the approximation will break badly. If you need more or for more than ten years you need proper cash flow with investment returns and modeling how they can vary.

However, 3% of capital as income is pretty conservative and 4% or 5% is OK with loss of some capital, so there is a fair amount of safety margin included. Just don't push it beyond the limits I've given without doing a less approximate calculation that accounts for reduced income due to spending of some capital early on...

Why did I use 110 years as the age? Because that's close to being forever when it comes to planning and I used 3% which is also a long term sustainable income level. It also helps to set a good context for how long a very prudent person should plan their income needs for.

SeniorSam

Just spent time looking at the figures and need to clarify only the ' £8,347 = 278250 invested tax free taking just 3% income' line and where that comes from please.

Based on the figures you have given, we could generate more income than we have been without going into higher rate tax. More by allocating taxable income to my wife.

I had not worked this out as well as you have, but had been considering 3-4% as a viable withdrawal to maintain a good income. Just checked the SIPP value again and its now at £326,298 which is an increase of £25,768 since the start of the year ................... looking good!

You have helped a great on this and hopefully others will lean from it also.

Sam

jamesd

That is from my previous post "£200k of other savings and investments plus the £78,750 lump sum is £278,750". 3% of that is £8,347. The 200k is from your "Additional assets of National Savings and ISA's are about £200k".

The new year has been good. Took me over the quarter million mark after a zero start about seven years ago.

SeniorSam

Thanks again James,
I have been looking at all the excellent answers so far, particularly from yourself and would appreciate knowing if I have understood the SIPP correctly from the information given so far.

The way I look at it, there can be 2 pots of pension funds. The present pot 'A' untouched, which if I die before taking anything can be paid tax free to my wife, or she could choose to take a pension with it.

A second pot 'B' ( empty at present, awaiting action ), could be created by crystallising all or part of pot 'A' and moving that to pot 'B', where I could take up to 25% tax free cash, as well as taking a drawdown pension, within GAD rates, of nothing or the maximum, which is 120% of GAD.

As an example, if pot 'A' was £320k, I could crystallise by moving it to pot 'B' and taking a maximum £80k tax free lump sum and up to the 120% of GAD rates on the balance of £240k.
Should I then die, my wife could take a pension from pot 'B' or take the balance less 55% tax. (?)

However, if the initial crystallisation from 'A' to 'B' was only £100k, leaving £220k in pot 'A' and I took the 25% tax free cash from pot 'B' and drew down a GAD pension or not, if I then died, my wife could have pot 'A' tax free and pot 'B' less 55% or a pension.

Sorry if I am a bit slow on the uptake, but need to understand fully before aking action.

Sam

GhIFA

Sam, yes you understand it correctly.

SeniorSam

Thank you GhIFA,

one final (I hope) question to clarify, when some crystallasation has taken place, can I still select and control which funds are used in both pot 'A' and pot 'B'. I would not like to release control of the investments as I have been doing so well for some time through my own choice of funds, including 8.5% in the last quarter.

Sam

jamesd

Yes, that's right. Until age 75.

I note that you're 72 now, so you'd really want to be thinking of the after age 75 rule, which has the 55% tax charge on lump sums paid outside the pension even if the pension pot isn't crystallised:

"How is an uncrystallised funds lump sum death benefit taxed? [s206]

It depends on how old the member was when they died.

If the member was under 75 when they died this lump sum will be tax free unless the lifetime allowance charge is payable.

If the member was aged 75 or more the lump sum will be taxed at 55 per cent. So if a £100,000 lump sum is payable the amount of tax due is £55,000. This tax charge is called the special lump sum death benefits charge. The scheme administrator is responsible for paying this tax."

You might look into using life assurance to pay any portion covered by a 55% tax charge. Taking drawdown income to pay for that is quite likely to leave you better off.

What can be done with the part that is in drawdown and the person reached age 75 from is covered at RPSM10101050. Which is just what has been discussed already. There was a change to the rules from 6 April 2012 and I'm describing only the rules from then in this post. The remaining important bits are covered in RPSM09100380 - Technical Pages: Member benefits: Overview: Authorised benefits: What happens at age 75:

"Age 75 reached on or after 6 April 2011

Any uncrystallised rights can remain uncrystallised but those not crystallised are crystallised for lifetime allowance purposes at the point age 75 is reached.

Lump sums such as pension commencement lump sums, trivial commutation lump sum and serious ill-health lump sum can be paid after reaching age 75, see RPSM09100360"

The ability to continue to take the tax free lump sum after age 75 was a major change.

A serious ill health lump sum is the amount payable to someone who is diagnosed with life expectancy that is likely to be less than a year.

RPSM17100000 Reached 75 between 22 June 2010 and 5 April 2011 covers the different rules for those who reached 75 within that date range. Other than that note, this post only covers the rules for those who reach 75 on or after 5 April 2011.