How to make the right type of withdrawal from your pension

Everything feels complicated when you’re contributing to a pension. But at the point of taking an income, you need to grapple with the worst pension jargon that’s ever existed. As more people access their pensions by drawing down on the investments, this means they may not be making the right type of withdrawals.

Among them are growing numbers of hard-pressed working people, well short of retirement, who are tapping their pots to get themselves through the cost of living crisis. Perhaps more worried about this month’s bills than their long-term savings, they might be particularly prone to taking hurried decisions that might later cost them more than they expect.

New HMRC stats show money withdrawn flexibly from pensions rose 15 per cent in the 2022-23 tax year to £12.9bn — an increase from £11.2bn in 2021-22 and £9.3bn in 2020-21. Some savers aged over 55 might have been looking to their retirement savings to cope with the escalating costs of living. 

The average withdrawals per person have remained largely the same over the past three years at just over £7,000 per quarter, with indications that many are taking sensible regular payments.

What worries me more is whether by ditching the traditional route of exchanging the investment for an annuity, people are mistakenly drawing down in the wrong way. This brings me to “uncrystallised funds pension lump sum”, the winner of my wooden spoon award for jargon, shortened by most industry experts to UFPLS.

A UFPLS, introduced since government reforms in 2015, is a simple way to draw your pension — but not necessarily the best. It means taking money directly from the pension pot you have built up and taking it either all in one go, or in chunks where 25 per cent of each chunk is tax-free and the rest is taxable at your income tax rate. 

If you’re wondering about the word “uncrystallised”, the term means that pension pot funds have not yet been used to provide a benefit. That’s the opposite of a “crystallised” pension fund that has an annuity, a drawdown scheme or has had a tax-free lump sum withdrawn from it. 

The more common alternative to UFPLS is to use “flexi-access drawdown” — a slightly more user-friendly term to describe moving some or all of your pension savings into a drawdown fund after you reach 55. Flexi-access drawdown allows you to take the 25 per cent tax-free lump sum on its own, without also taking taxable income. The remaining 75 per cent can continue to grow in your drawdown fund, tax-free, and you can access it whenever you want.

Generally speaking, the key advantage of flexi-access drawdown is the option to take tax-free cash without any taxable income. This is especially important if you are still working and paying tax.

Many people nonetheless choose to take UFPLS because it lets them delay big pension decisions, such as whether to set up drawdown or buy an annuity. If you haven’t yet made up your mind how to access your pension in the long term, you can use UFPLS in the meantime.

But if you don’t change your underlying pension fund investments, they may not be ideal for taking withdrawals. If a fund has high equity exposure and the stock market falls, it can then be harder to recover while making withdrawals. Plus, without a well thought through plan, you risk withdrawing too much in one go, while you can’t take the big 25 per cent tax-free lump sum that’s available with other options. 

UFPLS users should also be aware that the Money Purchase Annual Allowance kicks in when you start taking income from your pension pot. This caps further tax-free contributions to your pension at £10,000 a year — compared with the annual £60,000 cap available to other pension savers. This can be a significant disadvantage, particularly for those who lose a job and find they need to tap their pension funds before later finding work. 

Most importantly, since 75 per cent of each chunk taken through UFPLS is taxable, you may pay more tax than necessary if you withdraw more than you really need. And you may fall into another tax trap.

Since 2015, HMRC has chosen to tax the first flexible withdrawal someone makes in a tax year on a “Month 1” basis. This means it divides your usual tax allowances by 12 and applies them to the withdrawal, landing hard-working savers with shock tax bills often running into thousands of pounds. This is because you may expect to be taxed on the withdrawal at the 20 per cent basic rate but it could be taxed at up to 40 per cent. The rule can leave many paying more tax than they need — but may result in additional rate taxpayers underpaying.

While those who take a regular income or make multiple withdrawals during the tax year should be put right automatically by HMRC, anyone who makes a single withdrawal will probably be left out of pocket.

It is possible to get your money back within 30 days, but only if you fill out one of three HMRC forms to reclaim your money. If you don’t, you are left relying on the efficiency of HMRC to repay you at the end of the tax year.

In April, AJ Bell analysis of HMRC data revealed savers have now reclaimed more than £1bn in over-taxation on pension withdrawals since 2015. More than £48mn was repaid to 15,856 people overtaxed on pension withdrawals in the first three months of this year — the highest Q1 figure on record and second highest of any three-month period since April 2015.

We need to rapidly move to a system where the right tax is paid on withdrawals when people access their money. The big pension shake-up announced by Jeremy Hunt in his last Budget provides this opportunity.

There’s still a lot to iron out, but from what we know so far, UFPLS will remain a benefit option after the pensions lifetime allowance is abolished. However, the maximum tax-free sum will be £268,275, except where protections apply, which may be a bit trickier to regulate when it’s not drawn in one go.

In the meantime, there must be a better phrase than uncrystallised funds pension lump sum. Becky O’Connor, director of public affairs at online pension provider PensionBee, suggests “part and part withdrawals” or “direct access withdrawal”.

She explains: “You don’t ‘enter drawdown’ with it and the downside of that is you can’t take just a tax-free lump sum on its own but has to be ‘part and part’.” Either of these options are better than a definition that leaves most people none the wiser.

Moira O’Neill is a freelance money and investment writer. X: @MoiraONeill, Instagram @MoiraOnMoney, email: moira.o’neill@ft.com.