What’s the best way to use my pension pot?

Pension pots

A pension pot is the total amount that a person and/or their employer has put into one or more money purchase or defined contribution pension schemes. Traditionally, most retirees with a private pension have opted to take an annuity, but there are now many more choices available which can help you make the most from your pension pot.

Understanding these options, and getting expert help and advice, can help ensure you and your dependents have a reliable and tax-efficient retirement income for the rest of your life. Any money remaining in your pension pot on your death can be passed on to your inheritors (tax free if you die before the age of 75), so it’s worth considering this as part of your inheritance planning.

Following are the six most common ways to use your pension pot and the pros and cons of each option. When deciding on the best choice for you, be sure to shop around – not all pension schemes or providers will offer every option and you could get a much better deal elsewhere.

1. Leave your whole pension pot untouched

The normal minimum age to access your private pension pot is 55 (although this is due to rise to 57 in 2028 alongside increases in the State Pension age). However, there is no default retirement age and more people are choosing to either carry on working for longer or to cut back their hours gradually.

If you don’t need to access your pension pot, you can choose to delay taking any of your pension until a later date. This means the money in your pot will continue to grow tax-free, providing you with more income once you access it, and that the amount in your pot will have to cover a shorter period of time.

However, as with every investment, it’s possible that the value of your pot could go down instead of up. Your provider may also charge you extra fees is you don’t start taking your money once you reach your selected retirement age.

2. Using your pot to buy an annuity, or guaranteed income for life

Still the most common choice for pension pots, an annuity is an insurance policy that gives you a guaranteed income for the rest of your life (or for a set number of years). There are different types of annuity that affect how much income you could get.

When you purchase an annuity, you can normally also choose to withdraw up to 25% of your pension pot as a one-off tax-free lump sum. The remaining 75% is used to buy your annuity and you’ll pay tax on the income from this.

The big advantage of annuities is that, regardless of what happens in the markets, you know exactly how much you’ll receive and when you’ll receive it. It’s extremely important to compare all the available options to make sure you get the highest level of income for your circumstances.

The main disadvantage is that once an annuity is bought, you don’t have the option to change your mind and you’re stuck with that decision even if your circumstances change. A standard single life annuity will also not provide any income to your dependents once you die – you’ll need to choose a different type of annuity if that is a concern.

3. Flexi-access drawdown – using your pot for an adjustable income

Rather than use your pension pot to buy an annuity, you can instead invest it into funds designed to give you a regular taxable income. This income is adjustable, so you can choose to change how your money is invested or take cash sums if you need to. Pension changes that came into effect in April 2015 mean that there are now no limits on how much or how little you can take from your drawdown fund each year.

Again, you can choose to take up to 25% of your pension pot as a tax-free lump sum when you reach retirement age.

This option gives you more flexibility than a lifetime annuity and allows you to access larger lump sums from your pension if you need them. If you have more than one pension, you can take an income from one and continue to pay into the others. It also allows you to leave your money to someone when you die, but they may have to pay tax on it.

However, as your income isn’t guaranteed for life, you’ll need to manage your investments carefully and adjust them periodically if performance drops. It can be very difficult to work out which investments will give you the right balance of income and risk, so it’s definitely worth using a financial advisor to help create an investment plan.

Not all pension providers offer this option. You can transfer your pot to another provider if your current provider doesn’t offer it, but this is likely to incur a fee. Your provider is also likely to charge you a fee for managing your investments and whenever you get a payment.

You have a pot of £100,000 and take a tax-free lump sum of £25,000. You invest the remaining £75,000 and receive an annual income of £4,000, of which £800 will be due as tax.

4. Take out cash in chunks

Rather than using your pension pot directly to provide you with an income, you can instead choose to take cash sums out as and when you need them and leave the rest in your pension where it can continue to grow tax-free.

The tax implications for this option are slightly more complicated, but essentially for each cash withdrawal, 25% is tax-free and the rest counts as taxable income. Again, if you have more than one pension, you can take cash from one and continue to pay into the others.

This option is a good idea if you still have an income from another source but want to top up your funds occasionally. It also allows you to invest income elsewhere, eg in property, rather than leaving it in your pension.

Choosing this option does mean that your pension will stay as it is and won’t be invested into new funds designed to pay you an income. If your provider does not offer this option, you can transfer your pot but this may incur a fee. Your provider may also charge fees each time you make a cash withdrawal, or limit the number of withdrawals you make each year. Be aware that taking cash chunks from your pension pot may also affect the benefits you receive.

You have a pension pot of £100,000 and choose to take out £5,000 each year. You are also continuing to work part-time and earning £15,000 a year. 25% of your cash sum, or £1,250, is tax-free. The remaining 75% added to your annual earnings is £18,750, which is £7,250 more than the standard Personal Allowance of £11,500, giving you a total tax bill of £1,450.

5. Take your whole pot in one go

Rather than using your pension to provide you with a retirement income, you can instead choose to close your pension and take the whole amount as cash in one go. 25% of this lump sum would be tax-free and the remainder would be taxed. If you have more than one pension, you can choose to cash one in and keep the others.

The main reason for choosing this option is to invest the money elsewhere. However, there are many risks associated with cashing in your entire pension, so it’s vital to get guidance before you commit. You won’t have a secure retirement income and could potentially run out of money.

Taking out your entire pension in one go is also likely to land you with a very large tax bill and may affect any benefits you receive.

6. Mix and match your options

Don’t want to commit yourself to one option? Don’t worry – you can choose to mix your pension options and take cash and income at different times to suit your current requirements.

For example, you could take a cash lump sum, use some of your pot to get an adjustable income and the remainder to buy an annuity. And if you have multiple pension pots, you can use different options for each pension. You can also keep saving into a pension and get tax relief up to age 75.

When you’re deciding on which combination is right for you, you’ll need to consider your age, any health issues, whether you are likely to continue working, if you have any dependents and any other savings you or your partner have. You’ll usually need a fairly substantial pot in order to have enough to mix your options.

Your pension pot is £100,000. You choose to take 25% as a tax-free sum, leaving £75,000. Of this, you choose to leave £25,000 in a pension and withdraw £5,000 a year for the next 5 years. You use the remaining £50,000 to buy an annuity which will give you a small taxable income for life.

Get expert advice

You now have more options for using your pension pot than ever before, but that also means there are more ways to risk losing your pension. Before you make a decision, it’s vital to get advice and make sure you know which option is best for you. The government offers a free service called Pension Wise that can help you understand your choices, but you’ll also need to talk to a financial adviser for advice on the particular product(s) that’s best for you.

John Lamb are an FCA registered firm of Chartered Financial Planners. We have the expertise and knowledge to advise you on the most profitable and tax-efficient way to use your retirement income, as well as passing on as much as possible after you die.

For more information, download our Guide to Income Drawdown.

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