How to tax-efficiently manage your income in retirement

Even after you’ve stopped working your income remains subject to the usual tax rules, and there can be enormous variations in the proportions of tax paid. According to Pensions Policy Institute research, the tax one person might pay in retirement could be up to 200 times higher than another person’s, just because of the way they take their incomes (1).

So it’s vital to carefully think about how you take your retirement income. Here are some basic tactics to consider.

At age 55 (or 57 from 6 April 2028) you’re allowed to take out the whole amount of the defined contribution pension funds you may have contributed to over the years. With defined contribution pensions, the retirement funds you build up are dependent on how much you and your employer contributed and how these investments performed.

As tempting as it might be to take all your pension in one go, some restraint could be beneficial. This isn’t just to avoid ending up scrimping while the sports car rusts in the garage. It’s also because taking everything at once could mean a huge chunk of it goes to HMRC. If you push your income for any year into the highest tax bracket, your tax rate is bumped up to 45 percent. That could be lot of hours of working life to hand over in tax.

So carefully timing your retirement income can be crucial. And spreading your pension fund withdrawals across different tax years could lead to big tax savings.

Strategies to stay below key tax thresholds

More positively, pension rules allow you to take 25 percent of your pension savings without having to pay tax. But just because it’s tax free, it still may not be the best idea to take the lot at once. Drip feeding the tax-free cash, and combining it with other taxed income, could help keep you below one of the income tax thresholds, and so lower your tax rate.

Another benefit of leaving more tax-free cash in your pension pot, is it can remain invested, and could continue to increase in value, although this is not guaranteed. That also means the remaining 25 percent tax-free element would have the potential to grow. This would hopefully leave you with a larger amount of tax-free income to draw on in the future.

The strategy of spreading income across several tax years, to benefit from your annual personal allowance and keep below key tax thresholds, applies to non-pension income as well.

HMRC will want to add up all your income to assess your taxable earnings and tax rate. This includes workplace pensions, annuities, income from savings and investments, and any work you may still undertake. Even your state pension is taxed before it’s paid to you. Many state benefits are taxable too, including carer’s allowance.

Tax bands and tax allowances

In terms of income tax, in most of the UK the first £12,570 of your annual income is generally tax free. Any income from £12,571 to £50,270 is taxed at 20 percent, while income between £50,271 and £125,140 is taxed at 40 percent. Finally, any amount above £125,140 is taxed at 45 percent. Tax rates and bands are different if you live in Scotland.

You can obtain retirement income from many different sources. An adviser can review all your finances holistically and help you make good use of them.

The personal savings allowance means you can receive interest payments, up to specified levels, tax-free. Even if your income is between £50,271 and £125,140 you can still receive £500 in savings interest each year without paying tax on it.

If you have shares, you can earn £500 in tax-free dividend income each year. Above that you’ll pay a percentage of your dividend income in tax, depending on which income tax bracket you fall into.

You’re also allowed to make some capital gains each year, tax-free. Capital gains tax is paid on any profits you receive from cashing in something that’s gone up in value, that isn’t already sheltered from tax in an ISA or pension. For 2024/25 the tax-free allowance is £3,000.

With ISAs, however, everything you’ve saved or invested is held tax-efficiently. If you’re married or in a civil partnership, you could spread your income and savings between you, to make the most of your individual tax-free allowances.

Think about inheritance tax

But remember that ISAs and other investments will be liable for inheritance tax, unless you’re passing assets to a spouse or civil partner. In contrast, funds inherited from your pension pot aren’t usually subject to inheritance tax or subject to income tax if you die before the age of 75.

So with inheritance in mind, you may perhaps want to withdraw cash from other sources than your remaining pension pot. As a general guide, if you’re facing income shortfalls in retirement and you want to maximise the wealth you pass on to loved ones, then you may benefit from using cash first, then investments, and pensions last of all.

However what is right for you will depend on your specific circumstances and trying to maximise your retirement income and tax savings can be a delicate balancing act. At Schroders Personal Wealth one of our key principles is to have regular reviews with an adviser. An adviser could help you create and maintain a retirement income plan that matches your own particular goals and circumstances.

Source:

(1) Pension Policy Institute (PPI, www.pensionspolicyinstitute.org.uk), ‘How will the evolving retirement landscape impact tax and benefits?’, October 2018.