Choosing a taxable income for the rest of your life
You can normally withdraw up to a quarter (25%) of your pot as a one-off tax-free lump sum, then convert the rest into a taxable income for life called an ‘annuity’. There are different lifetime annuity options and features to choose from that affect how much income you would get. You can also choose to provide an income for life for a dependent or other beneficiary after you die.
A lifetime annuity is a type of retirement income product that you buy with some or all of your pension pot. It guarantees a regular retirement income for life. Lifetime annuity options and features vary – what is suitable for you will depend on your personal circumstances, your life expectancy and your attitude to risk.
You can normally choose to take up to 25% (a quarter) of your pension pot – or of the amount you’re allocating to buy an annuity – as a tax-free lump sum. You then use the rest to buy an annuity, which will provide you with a regular income for life. This retirement income is taxed as normal income.
There are two types of lifetime annuity to choose from: basic lifetime annuities, where you set your income in advance; and investment-linked annuities, where your income rises and falls in line with investment performance, but will never fall below a guaranteed minimum
Basic lifetime annuities
Basic lifetime annuities offer a range of income options designed to match different personal circumstances and attitude to risk. You need to decide whether you want one that provides an income for life for you only – a ‘single life’ annuity, or one that also provides an income for life for a dependant or other nominated beneficiary after you die – called a ‘joint life’ annuity.
Payments can continue to a nominated beneficiary for a set number of years (for example, ten years) from the time the annuity starts in case you die unexpectedly early – this is called a ‘guarantee period’.
‘Value protection’ is less commonly used but is designed to pay your nominated beneficiary the value of the pot used to buy the annuity, less income already paid out when you die. Your choices affect how much income you can get. Where you expect to live when you retire might also affect how much income you get.
If you have a medical condition, are overweight or smoke, you might be able to get a higher income by opting for an ‘enhanced’ or ‘impaired life’ annuity. Not all providers offer these, so be sure to shop around if you think you might benefit from one. If you have a single annuity and no other features, your pension stops when you die.
Investment-linked annuities also pay you an income for life, but the amount you get can fluctuate depending on how well the underlying investments perform. If the investments do well, they offer the chance of a higher income.
However, you have to be comfortable with the risk that your income could fall if the investments don’t do as well as expected. All investment-linked annuities guarantee a minimum income if the fund’s performance is weak.
With investment-linked annuities, you can also opt for a joint or single annuity, guarantee periods, value protection, and higher rates if you have a short life expectancy due to poor health or lifestyle. Not all providers will offer these options.
Open Market Option
If you decide an annuity is right for you, it’s important to shop around. This allows you to turn your pension pot into an annuity rather than accept the rate offered by your pension provider – this is called an ‘Open Market Option’.
Introduced as part of the 1975 Finance Act, the Open Market Option allows someone coming up to retirement to select the best annuity or retirement option from the whole of the market rather than taking the default option from their current pension provider.
By obtaining professional advice and searching the entire market, this could increase a pensioner’s retirement income by as much as 30%. Not automatically choosing your current provider’s option can really make a difference and will help to maximise your income in retirement.
If you die before age 75, any lump sum payment due from a value protected annuity will be paid tax-free. Income from a joint annuity will be paid to your dependant or other nominated beneficiary tax-free for the rest of their life. If you die within a guarantee period, the remaining annuity payments will pass tax-free to your nominated beneficiary, then stop when the guarantee period ends.
If you die aged 75 or over, income from a joint annuity or a continuing guarantee period will be added to your beneficiary’s other income and taxed as normal. Joint annuity payments will stop when your dependent or other beneficiary dies. Any guarantee period payments stop when the guarantee period ends. Any lump sum due from a value protected annuity will be added to your beneficiary’s income for that year and taxed as normal.
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