Planning income in retirement is never straightforward, especially where tax is involved. If you have managed to set aside £2m in pension savings you could face some hefty tax bills. Savers should come up with a clear plan of how to minimise their liability before making any withdrawals.
You will have to grapple with the “lifetime allowance”, which places a limit on how much you can have in your pension, without incurring extra tax. This tax year, the allowance is £1,073,100 and it increases every year with inflation.
Pension providers must tell you how much tax you owe if you go above your lifetime allowance and this sum is deducted before you receive your pension. The charge will be 55pc if you decide to take the excess as a lump sum or 25pc if it is taken as an income, for example as an annuity or drawdown. You will also have to pay tax at your marginal rate on your income.
Claire Trott of St James’s Place, a wealth manager, said the amount you pay in tax will depend on whether you have any lifetime allowance protection.
You can shelter your pension from the full effects of the LTA. In April 2016 the lifetime allowance was reduced from £1.25m to £1m and those impacted could apply to limit the effects of the 2016 reduction, protecting them up to £1.25m.
This could save a charge of nearly £100,000 if the excess is taken as a lump sum or nearly £45,000 if it was later drawn out as income. Protection was available depending on your circumstances each time the lifetime allowance was cut over the past 15 years.
Thousands of savers, however, will not have protection and will be forced to navigate the web of lifetime allowance rules.
Those who want to keep their taxable income down could use some of the tax-free cash they can withdraw each year to remain as a basic-rate taxpayer while being able to access significant levels of income, Ms Trott said. Even with a pension of £2m it is important to factor in the state pension, as it will add £9,110 to your yearly income.
She said: “Taking advice and making a plan for withdrawals in drawdown and reviewing this plan on a regular basis is key, especially if there are any changes in taxation that may impact your plans.”
Those with £2m in their nest egg may not be concerned about running the pot dry any time soon but depending on how and when they take their income, overpaying tax could become a problem.
Say you wanted to pay off a mortgage or help their children get on their property ladder by taking £85,000 from your pension. If you had already used the tax-free cash then it would be taxed like any other income. To receive the £85,000 you would need to draw nearly £130,000 from your pension while paying nearly £45,000 in tax, Ms Trott said.
Spreading out payments over several years means you can avoid higher-rate, 40pc, tax entirely. But be warned, because of the “pensions emergency tax” problem you might end up needing to reclaim overpaid tax.
Taking too much out too early can also stunt the growth of your fund. Regardless of the way you draw from your pension, you can still reinvest the money you do not need to protect your savings against inflation eroding away their value over time.
This can generate investment returns and grow the size of your pot even if you are drawing down from it. If you invest your pension money into the stock market, it is important to make sure you are comfortable with the risks you are taking.
The money remaining in your pension is protected not only from immediate taxation but also from inheritance tax if you do not spend it before you die.
Ms Trott said: “This can be a good reason to consider your whole financial situation each time you need to draw income, as taking it from a variety of assets can reduce lifetime taxation as well as any taxes your beneficiaries may pay on your death.”
Choosing a fixed rate of drawdown is a good place to start if you want to get an idea of how much income you are likely to be able to pay yourself for each year of your retirement.
But first you must decide if you want to cash in on the tax-free lump sum or leave your pot intact.
If you withdrew the full amount the year you leave work for good, let’s assume at the state pension age of 66, you could still expect a generous income for decades to come. For simplicity we are also assuming the lifetime allowance will not be a problem, though in reality it is likely to be.
If you decide to take 5pc of the initial starting pot, you would still have £1.36m by the age of 95, assuming 5pc investment returns each year (see table, below). This would pay out £100,000 a year, rising to £109,110 when combined with the state pension.
However, if you increase this to a 7pc drawdown rate, you would run out of money by 90. https://cf-particle-html.eip.telegraph.co.uk/0abc0d52-8c57-4a78-b44a-352b8adc3399.html?ref=https://www.telegraph.co.uk/money/consumer-affairs/spend-ultimate-drawdown-plan-2m-pension/&title=How%20to%20spend%20it:%20ultimate%20drawdown%20plan%20for%20a%20%C2%A32m%20pension
The maximum you could reasonably withdraw from your pension each year without running out of money too soon is 7.58pc for women and 8.04pc for men, according to pension provider Quilter. That would require drawing out £151,000 from your pot each year and could leave those who live beyond the average life expectancy vulnerable. For this article we are assuming men live to 85 and women to 87, based on ONS life expectancy at age 66.
Take more early on
A fixed rate of withdrawal is a simple way to plan your income but in reality a lot of new retirees will want to spend more in their active years after they give up work. It could make sense to set aside more money for the first decade or so to meet the costs of hobbies and travelling, for instance, before cutting withdrawals in later years.