Pension schemes you arrange for yourself are always defined-contribution pensions, so all of the information in the last four sections applies (except there are usually no employer contributions).
Anyone can have a pension scheme, and anyone else can pay into it for you – for example, if you’re caring for children or doing other unpaid work, your partner could pay into a scheme for you; and grandparents, say, could pay into a pension scheme for grandchildren even from the day they are born. But usually people arrange their own scheme in order to top up the savings they are building up through their workplace scheme or because they are self-employed.
There are several types of personal pension scheme:
- Stakeholder pensions must have certain features, including capped charges, low minimum contributions, flexible contributions, penalty-free transfers and a default investment fund – i.e. a fund your money will be invested in if you don’t want to choose one yourself.
- Standard personal pensions are similar to stakeholder pensions, but they usually offer a wider range of investment funds. Personal pension charges may be similar to stakeholder pension charges or lower (sometimes much lower), but some are higher.
- A self-invested personal pension (SIPP) gives you an even wider choice of investments, including for example property, direct investment in stocks and shares, as well as a huge range of investment funds. The charges for SIPPs are usually higher than for other types of personal pension, so make sure you really do want the greater range of options they offer.
Stakeholder schemes and standard personal pensions are typically provided by insurance companies, while SIPPs tend to be offered by stockbrokers and investment firms, often through online platforms.
Another option if you are self-employed is to join NEST. It has been designed with relatively low charges in order to offer good-value pensions, but has only a limited range of investment choices. For more information, visit NEST (Directory, p 32) and search for ‘Joining as self-employed’.
Starting your pension
A company pension scheme usually has a normal pension age which is the earliest age at which you can start to draw your full pension. With a personal pension scheme, you choose the age at which you want it to start.
You can often choose to start your pension earlier but, in that case, the amount of pension you get from a company defined-benefit scheme will be lower and stay at that lower level throughout your retirement. Similarly, with a company defined-contribution scheme or any personal pension scheme, the pension pot you’ve built up (and so the amount of pension it can provide) will be permanently lower if you retire early. Some company schemes pay a higher amount of pension for a few years to bridge the gap between your retiring early and your State Pension starting. The extra amount is called a ‘bridging pension’ and the whole arrangement is some-times called a ‘step-down pension’. It’s important to understand this arrangement if it applies to you so you are not taken by surprise when your company pension falls at State Pension age.
The earliest you can normally start drawing a pension is currently age 55. This is due to rise to 57 in 2028 when State Pension age reaches 67. You can start your pension at any age if you have to retire early because of ill health. Starting your pension later may mean you get a larger pension.
Some employers have rules that prevent you continuing to work for them after starting your pension or limit the number of hours you can work – check your scheme rules to see if this applies. But there is no general rule stopping you working and drawing pensions, so you could take work else-where or start your own business. It is now increasingly common for people to gradually phase into retirement, combining work and pension.
Drawing your savings early
Since April 2015, with many defined-contribution schemes, provided you have reached at least age 55 (57 from 2028), you can draw out some or all of your savings before retirement to use in any way you choose. Your pension provider can tell you if it offers this option; if not, you might consider transferring your savings to another scheme that does.
These early withdrawals go by the ungainly name of ‘uncrystallized funds pension lump sums’ (UFPLS). ‘Uncrystallized’ means that you have not yet turned your pension pot into an annuity or drawdown fund, so your savings are still in that first (accumulation) stage.
A quarter of any sum you draw out in this way is tax-free, but the rest counts as taxable income for the year you make the withdrawal. This can come as a shock, especially if it tips you into a higher tax bracket, as in the case study following. You might pay less tax if you take several smaller lump sums spread over several years.
Tax on an UFPLS withdrawal is usually deducted automatically by the provider using the PAYE system (which is explained in Chapter 4). The system is designed to cope with regular payments rather than large one-off lump sums and can result in the wrong amount of tax being deducted. You would then need to claim a tax refund (or, less usually, have extra tax to pay) – how to do this varies with circumstances. You can find out more using the tool at GOV.UK (Directory, p 36).
CASE STUDY
John is normally a basic-rate taxpayer (paying a top rate in 2023/24 of 20 per cent), and his income is £5,000 below the threshold at which higher-rate tax starts. He decides to draw £50,000 out of his pension savings. A quarter of this (£12,500) is tax-free. The remaining £37,500 is added to his income for the year and taxed in the normal way. £5,000 uses up his remaining basic-rate band, but the rest is taxed at 40 per cent. The total tax bill on his UFPLS withdrawal is £14,000. After tax, his £50,000 withdrawal has shrunk to £36,000.
You cannot make UFPLS withdrawals from a defined-benefit scheme. However, if the scheme is run by a private-sector employer, you could trans-fer your pension rights out of that scheme and into a personal pension scheme that does allow early withdrawals. You should think carefully before doing this, because you will be giving up a secure promised pension that you might need in retirement. If the value of the pension rights you are transfer-ring comes to more than £30,000, you will in any case have to take professional financial advice.
If you belong to a public-sector defined-benefit scheme, you are not allowed to transfer your pension rights to a defined-contribution scheme.
Drawing your savings early affects your Annual Allowance (described in How much you can save earlier in this chapter). The limit on the amountyou can save in future each year through defined-contribution pension schemes is capped at £10,000.
The tax-free lump sum
As mentioned earlier, a quarter of your pension savings can be taken as a tax-free lump sum (up to a maximum sum of £268,275 in 2023/24). Tax-free
money is a good thing, right? However, taking a lump sum means there is less money left in your pension pot to provide your retirement income, which may then be less than you would like. Fortunately, there are several ways in which you can maximize your pension income while still getting the benefit of the tax-free lump sum:
- Use UFPLS withdrawals to create a stream of income. A quarter of each withdrawal is tax-free, as described in the previous section.
- Opt for ‘phased retirement’. This is where, each time you need an income payment, you use just part of your pension pot. You can take a quarter of that part as a tax-free lump sum and put the rest into drawdown. You don’t have to take any income from the drawdown fund and could just use each tax-free sum as your ‘income’.
- Buy a purchased lifetime annuity (PLA). You take a quarter of your whole pension pot as a tax-free lump sum and use the rest for drawdown or to buy an annuity. However, you use the tax-free lump sum to buy a PLA. This is similar to the type of annuity you buy with your pension pot, but taxed in a different way. There is more information in Chapter 5.