Since the pension freedoms which came into force in April 2015, income drawdown has proved to be a popular option for individuals who want greater control and freedom over how they access their pension savings.
However, those who choose to go down the income drawdown route will need to make sure they don’t pay any unnecessary income tax.
Usually 25 per cent of a pension is tax-free, and the remaining 75 per cent is taxed as earned income – but with careful planning it is possible for individuals to pay very little income tax, especially in the early years of drawdown.
WEALTH at Work has created three fictional case studies that demonstrate how individuals can create the most tax-efficient retirement income, in some cases making it possible to pay very little income tax in the early years.
All case studies assume Isa returns of 5 per cent and interest available on taxable cash deposits of 1.4 per cent gross.
Case study 1
Peter is aged 60. He has a defined benefit (DB) pension (also known as a final salary pension) which will pay £8,000 a year; a defined contribution (DC) pension fund (also known as a money purchase pension) worth £300,000; Isas worth £50,000; and £10,000 held in cash. He is planning to retire in April 2018, and would like to generate an initial annual income of £20,000 a year after tax and to retain the £10,000 as an emergency cash reserve.
Using the method outlined below it is possible for him to do this without paying any tax in year one – even though £20,000 is almost double the personal allowance of £11,500 for 2017/18 – by using his Isa and flexi-access drawdown (FAD) for income.
Peter can withdraw £2,500 of tax-free returns from his Isa, leaving £17,500 to find. He has a personal allowance of £11,500 so he does not need to pay tax on the £8,000 from his DB pension and consequently will have £3,500 of unused allowance available.
He therefore needs a further £9,500 to have the £20,000 income he is looking for. To be able to do this he could crystallise £24,000 of his DC pension using FAD. Of this, £6,000 (25 per cent) can be taken as a tax-free cash lump sum and £3,500 withdrawn as an income to utilise the remainder of his unused personal allowance. By doing this he will have the £20,000 he is looking for, tax-free. The other £14,500 will remain in his pension as a ‘crystallised’ fund with the potential to grow and which can be drawn from in future years.
Case study 2
Mary is in exactly the same financial position as Peter, but is eligible for the full New State Pension. As the combined income from her DB scheme and state pension will be higher than the personal allowance, she will need to pay some tax, but will not need to pay any further tax up to the £20,000 annual income she is hoping for.
Mary has a personal allowance of £11,500. The combined income of £8,000 from her DB pension plus £8,296 new State Pension gives her a gross income of £16,296. Income tax payable on this would be £959, leaving a net income of £15,337.
To achieve her aim of an income of £20,000 a year, she can supplement this with £2,500 interest from her Isa and £2,163 of tax-free cash from her DC pension fund. To do this, she would need to crystallise £8,652 using FAD; of this, £2,163 (25 per cent) can be taken as a tax free cash lump sum and £6,489 would remain as a ‘crystallised’ fund in her pension with the potential to grow.
Case study 3
David, aged 60, is looking to retire in April 2018. He is in a similar position to the case studies above, except that he is not yet eligible for his state pension, his DC pension is £200,000 and has taxable cash deposits of £100,000 as well as an Isa of £50,000.
To achieve his aim of an income of £20,000 a year tax-free, he could use the £8,000 from his DB pension and £3,500 from the taxable part of his DC pension fund to use up his personal allowance (£11,500). He would need to crystallise £4,667 of his pension to be able to withdraw £3,500 (75 per cent) in taxable income, and £1,167 (25 per cent) would be paid as a tax free cash lump sum (£3,500 + £1,167 = £4,667).
This could be supplemented with £2,500 interest from his Isa and £1,400 interest from his savings (£100,000 at 1.4 per cent), which would not be taxed because the starting rate for savings income is £5,000. Alternatively, as it is better to leave as much money as possible in the tax-efficient wrappers of Isa and pension, David may choose to spend from his cash deposit to make up the £20,000 he is looking for.