Tax is a necessary evil, helping to fund everything from the NHS and the state pension to our schools and roads. But after paying taxes for 40-plus years, few of us want to pay more than we need to when we reach retirement.
Thanks to the pension freedoms introduced in April 2015, it’s easier to flex your income in retirement, helping you to minimise tax while also meeting your financial requirements. ‘My clients are often shocked when I tell them they can have a tax-free income of £40,000 or £50,000 a year in retirement,’ says Jade Connolly, head of financial planning at Ascot Lloyd. ‘But, if you save enough and you structure your retirement savings in the right way, it’s easy to achieve this level of tax-free income.’
The preparations start well before retirement, with Connolly saying the last five years or so are critical for ensuring your savings are in order. ‘You need to save as much as you can, but you also need to save into a variety of different investment vehicles, as this will increase your income options in retirement,’ she explains. ‘Also, check that your pension provider will allow you to take income flexibly in retirement, as not all do.’
The tax relief associated with pension contributions should make a pension the first choice for your savings, especially if you’re a higher-rate taxpayer. ‘Most people are basic-rate taxpayers in retirement, so you’ll get a decent tax kicker if you’re a higher-rate taxpayer when you make contributions. Even if you’re a basic-rate taxpayer in your working life, it’s still worth considering,’ says Nicholas Nesbitt, private client director at Mazars Financial Planning.
The maximum you can pay into a pension is 100 per cent of your earnings, subject to the £40,000 annual allowance and the £1 million lifetime allowance. You may also be able to use the ‘carry forward’ rules to take advantage of unused allowance from the previous three tax years.
Although you can keep paying into your pension until age 75, once you hit age 55 it’s important to be mindful of the money purchase annual allowance. Designed to stop people recycling pension savings to claim extra tax relief, this reduces the maximum you can pay in to £4,000 a year if you start to take money from your fund. ‘It’s not a problem if you take the tax-free cash from your pension, but if you withdraw any further income, this lower allowance will come into effect,’ says Nesbitt, ‘so be careful.’
Spread your savings
While your pension may be your primary consideration, it’s also important to take advantage of other allowances. ‘Use your £20,000 annual Isa allowance and move other investments and savings into Isas if possible,’ says Peter Brennan, chartered financial planner at EQ Investors. ‘You might also want to consider using your capital gains tax (CGT) allowance (£11,700 in 2018/19) if you’ve built up profits in investments you hold outside of Isas.’
The tax treatment of investment bonds means they can also be worth considering in the run-up to retirement. ‘These are tax-deferred, so can be particularly suitable if you’re likely to become a basic-rate taxpayer in retirement,’ explains Lee Clark, chartered financial planner at Brewin Dolphin. ‘Basic rate tax is deducted internally, and if you’re a basic-rate taxpayer when you cash the bond in there’s no further tax to pay.’
As well as spreading your retirement savings across different vehicles, it’s also worth checking your wealth is divided between you and your partner. This can mean taking advantage of their Isa and CGT allowances, which will make your combined savings and investments much more tax-efficient, and maybe also placing assets in their name to make full use of their personal income tax allowance (£11,850 in 2018/19).
Building up a pension in their name is another smart tax tip, even if you’re approaching retirement age. Even if they’re not working, they’re still entitled to a maximum annual pension contribution of £3,600, of which you pay £2,880 and the government the remaining £720 in tax relief. This not only secures this tax relief and a tax-efficient growth environment but, as Clark explains, it can have future benefits too. ‘If they’ve got their own pension, this makes it easier to take advantage of their income tax allowance in retirement,’ he says.
Taking your retirement income
Entering retirement with a range of investments alongside your pension means it’s possible to use your income streams flexibly to keep your tax bill to a minimum. ‘Use this range of investments to take advantage of your different tax allowances,’ explains Connolly. ‘Your pension can provide both tax-free and taxed income but you could also sell investments to use your capital gains allowance, or tap into your Isas for tax-free income.’
Keeping an eye on your tax allowances is key. As an example, take your income tax personal allowance. If you’re still working or receiving a pension, including the state pension, or you have other sources of income such as buy-to-let property, some or all of this allowance could already be used up. However, where it’s all been swallowed up already, and you’re married or in a civil partnership, you may be able to use the marriage allowance to release some of the lower earner’s tax allowance.
With this, providing one of you has income below the personal allowance and the other is a basic-rate taxpayer, the lower earner can transfer some of their personal allowance. In the 2018/19 tax year, this will be £1,190, saving you £238 in tax.
Your other tax allowances also need careful attention. From a capital gains perspective, you may wish to sell investments each year to use your CGT allowance. The proceeds could either go towards your annual income, or be sheltered more tax-efficiently in Isas.
If you have investments outside of Isas, you may also need to consider the dividend allowance, especially as this is dropping from £5,000 to £2,000 in 2018/19. Although you can soak up any additional dividend income in your unused personal allowance, you might want to think about shifting to assets that generate growth instead, and using your Isa holdings for income-generation. This is an area where a good financial planner should be able to add real value, so it may well be worth seeking expert advice to ensure all your assets are held as tax-efficiently as possible.
Pension contributions The tax breaks
Philip is a basic-rate taxpayer and his sister Penny is taxed at the higher rate. They each want to make a £1,000 contribution into their pension, so they pay in £800 with a further £200 added in basic-rate tax relief. As she’s a higher-rate taxpayer, Penny is also able to claim a further £200 in tax relief through her self-assessment.
When they reach age 55, they are entitled to 25 per cent tax-free cash, equivalent to £250 on this £1,000 contribution. Assuming they’re both basic-rate taxpayers in retirement, and that they’ve already used up their income tax personal allowance, when they withdrew the remaining £750, it would be taxed at 20 per cent, giving them £600.
For Philip that means he received a total of £850 for the £800 he paid into his pension. For Penny, as she received the extra £200 tax relief on the contribution, her total return for £800 is £1050.
If they stagger the withdrawal of the remaining £750 so as to take it without income tax being deducted, it would boost their return by a further £150, turning their two £800 contributions into £1,000 and £1,200 respectively.
Looking to the future
As well as thinking about your immediate tax position, it’s also prudent to think about future tax liabilities. Christy Morrison, head of wealth planning at WH Ireland, says this is particularly the case with pensions since the death benefit rules turned them into an effective inheritance tax (IHT) planning tool. ‘Lots of people use their pension for income in retirement, preserving their Isas and other savings and investments. But, unlike your pension, these are all in your estate for IHT purposes,’ she explains. ‘If you’ve got a future IHT liability, spending these other investments and leaving as much in your pension as possible could help reduce this.’
Additionally, if you can’t afford to leave your pension to the next generation, it’s worth thinking about how you take it, as this may also affect your future tax position. Nesbitt explains: ‘Many people take all of their tax-free cash in one go, but you might want to consider spreading it out over the years. By taking some tax-free and some taxable income each year, you could minimise the income tax you pay over your retirement.’
While pension freedoms offer much more flexibility around retirement income, the new environment also brings much more complexity, and it may make sense to take professional advice. Either way, planning ahead will ensure you, and not the taxman, benefit from the choice that’s on offer.
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