Tax Implications of Income Drawdown vs. an Annuity in UK

tax implications of income drawdown vs. annuity

By Ryan Smith –

Tens of thousands of people have this year been forced to rethink their retirements.

Chancellor George Osborne’s ‘pension freedoms’ were announced in the 2014 Budget Speech, with the biggest change being the removal of restrictions on people’s defined contribution schemes.

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As the pension freedoms have been introduced, and more and more enquiries are coming through to pension providers and retirement planners about income drawdown – and eschewing the traditional annuity – it’s important to remember that there will likely be major tax implications involved in drawdown.

It could result in the fabled annuity being the smart choice for many pensioners, providing a secure and stable income through retirement.

The key points about tax changes

From April 2015, the punitive 55% tax rate on withdrawing cash from your pension fund is to be scrapped. Instead, you will be taxed in line with your income at between 20-40%. But this only tells part of the story – there are wider tax implications.

Shock tax bill

While before the pension freedoms came in to effect, many were expected to withdraw and blow the pot all in one go. There were fears that this would result in a shock tax, with the cash taken from a pension pot being classed as income. This could mean retirees with even quite modest pots would easily find they are taxed at the top 40% rate following a complete withdrawal.

The experts advise that if you were to enter income drawdown that you take out smaller segments over the year. This can often negate the point of choosing income drawdown over an annuity – as at least the annuity is converted into a secure income, at no risk of devaluation from underperforming markets, or mismanagement resulting in a complete dwindling of a fund.

More flexible annuities

Loosening of tax rules will enable providers to come up with a broader range of products that allow pensioners to withdraw lump sums from their annuities, take a decreasing income or change how much they withdraw over the years. The changes will effectively open up flexible drawdown type products to a far wider range of retirees. However, experts suggest the changes could drive up the cost of annuities for those who do take them.

Flexible drawdown

Pensions already in drawdown will benefit from an increased annual allowance. They will be able to claim tax relief on contributions of up to £10,000 each year. But there are some key changes designed to prevent tax avoidance:

For example, if withdrawals are over the annual maximum limit for capped drawdown, yearly pension contributions will be restricted to £10,000.

If you are in a defined benefits scheme you will still be able to contribute up to £40,000 a year.

Inheritance tax

Inheritance tax could become more important for many. Annuities are essentially an income for life that cannot be passed on to anyone else after death. But as pension pots can be taken as cash and become part of an estate, inheritance tax may become another consideration for retirees if it pushes assets above the £325,000 level.

It’s always worth remember though that the new rules will allow you to essentially ‘mix and match’ your income options in retirement. You can choose income drawdown toward the start of retirement which can be protected to go toward your beneficiaries, before securing an annuity later in life.

Things that aren’t changing

Tax implications aside, some things will remain the same. Tax relief available during the accumulation phase is to remain the same, while there are also no changes planned for the 25% tax-free lump sum you can take from your pot on retirement.

Annuities also remain a valuable option, with no planned reforms to how these are taxed at time of writing.

Ryan Smith is part of the content development team at Compare Annuity, which provides a free annuity calculator for people to compare their annuity rates online

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Tax Implications of Income Drawdown vs. an Annuity in UK
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