‘How do I use pension drawdown to access tax-free cash?’

“I have been reading about pension drawdown but I’m finding it hard to understand how it actually works in practice. 

If my self-invested personal pension has a value of £200,000 and I decide I want to withdraw £25,000 in tax-free cash then my understanding is that in order to do this I must move £100,000 into drawdown.

That’s easy enough to grasp but what I’m struggling to wrap my head around is which £100,000 part of my pension is moved into drawdown and which isn’t? Can I decide this for myself?

If the answer is yes then what happens if I don’t want to sell any of my investments when I do this? Do I have to sell and buy them again if I’m moving them into drawdown?

Once my investments are in drawdown, how are subsequent increases or decreases in the values of the investments then taxed?

I’ve also been reading about withdrawing the natural yield but how would that work? If I’ve moved some of my pension into drawdown and it keeps generating cash, can I keep withdrawing it without having to move any more into drawdown?

What about any cash generated by that part of my SIPP that isn’t in drawdown?”

Steve Brown

If you’re struggling to get your money back or have a personal finance issue you would like us to investigate, write to us questions@timesmoneymentor.co.uk.

Troubleshooter says

Once you’re old enough to access your pension, which for most schemes is 55, you have a number of options of how to withdraw your money. 

This includes buying an annuity, which provides a guaranteed regular income, or pension drawdown, which gives more flexibility over how much to take from your pension pot. You could also use a mixture of these options. 

Our annuities versus drawdown guide outlines the pros and cons.

Pension drawdown applies to defined contributions schemes, where the value is determined by the amount you pay in and the performance of the investments. You can’t use drawdown for final salary pensions which provide a guaranteed income for life.

Before the pension freedoms were introduced in 2015, most retirees had no option but to buy an annuity from an insurer, so pension drawdown — sometimes known as income drawdown — is a relatively new concept. While it offers more flexibility than annuities, pension drawdown rules can be confusing.

To access your pension you need to “crystalise” some of it which means you’re cashing it in. Each time you crystalise a chunk of your pension, a quarter of it is tax-free.

So in order to access a £25,000 tax-free lump sum, you would have to disturb £100,000 of your £200,000 pension fund. This means the remaining £75,000 would be moved into a drawdown account. 

With drawdown, the £75,000 remains invested — or is reinvested — but you can take an income from that pot when you need it. But bear in mind that you could end up paying income tax on the amount you withdraw above the personal allowance of £12,570 a year.

You asked which part of your SIPP can be moved into drawdown and I’m afraid this will depend on your provider as there is no set way. Not all providers give their customers the option of drawdown either, which means some people have to transfer their pension funds elsewhere to take advantage of it.

Even if your pension provider does offer drawdown, make sure you compare it to other companies because the fees, funds and flexibility can vary. See our pick of the best pension drawdown providers.

If your SIPP is invested in a number of funds, Zoe Dagless from investment platform Vanguard explains that the funds can often be moved without the need to sell and repurchase the investments.

But while some providers let you choose which ones to move over to the drawdown account, others will just transfer a proportion of the funds you hold in your SIPP. 

In some cases, you will need to sell your existing funds to raise £100,000 which can then be reinvested in your drawdown account.

If the money in your drawdown account has increased in value because the investments have performed well then that growth will also be subject to income tax when you withdraw it. In other words, once you have moved money into your drawdown account, it won’t benefit from the 25% tax-free perk when you want to access it.

You also asked about withdrawing the natural yield. This is like skimming off the growth from your investments and leaving the rest of your pension fund intact so it can continue to grow.

Some of your investments might pay dividends or coupons and you can either choose to reinvest them or take the money as income. But again, any money you withdraw from your drawdown account will be subject to income tax.

Ammo Kambo from wealth manager RBC Brewin Dolphin said taking the natural yield from a drawdown arrangement can be a sustainable strategy. But if your investment funds don’t grow or even fall in value then you might have to dip into your actual pension instead.

If you still have £100,000 in your pension that’s not been crystalised, Kambo said you could run down your drawdown fund before allocating more of your uncrystallised pension to it.

Vanguard’s Dagless said one approach you could use to help your pension last longer in retirement is taking more income from your drawdown account when markets do well and taking less when they do badly.

You have to set a floor and a ceiling so that you have enough income to live on while also avoiding taking so much that you quickly eat into your drawdown fund. But in this way Dagless said you never withdraw too much or too little.

So what about any extra cash generated by the rest of your SIPP?

For the uncrystallised portion of the pension that isn’t in drawdown, this continues to grow in exactly the same way as before. 

Kambo said some pension plans allow your crystallised and uncrystallised funds to be managed by the same investment manager but the two pots would be invested slightly differently.

He added: “Sometimes the investment manager may manage both pots as one, ensuring the pension portfolio produces the required returns to maintain a sustainable withdrawal strategy.”

Our top pick of drawdown pension providers.