Tax efficient tactics for your retirement income

• Retirees must pay tax like everyone else.

• Be aware of tax-free allowances and tax thresholds.

• Planning how you generate your future income could help reduce your tax bill.

Even after you’ve stopped working your income is still subject to the usual tax rules. And the stakes can be high. According to Pensions Policy Institute research, the amount of tax you pay in retirement could be up to 200 times higher, depending on the decisions you make [1]. The new pension freedoms introduced in 2015 mean key decisions around retirement income are down to you if you decide not to convert your pension savings to an annuity.

It’s important to use your freedom wisely, or you could face expensive tax consequences. Here are some basic tactics to consider.

Resist the lure of the lump sum

If you’ve had a pension fund, or several, building up nicely over the years, you’ll find yourself allowed to take out the whole amount. Probably at age 55 but possibly from 57 in a couple of years’ time.

As tempting as it is to have it all, a little restraint could be a good idea. Not only because you don’t want to starve while the Ferrari rusts in the garage, but because taking everything at once most likely means the tax people will want a huge chunk of it. If you push your income for any year into the highest bracket, your tax rate is bumped up to 45% [2]. That’s a lot of hours of working life to hand over in tax.

Timing is crucial – spreading your pension fund withdrawals across different tax years could save you a substantial amount.

Think about spinning out your tax-free cash

You can take 25% of your pension pot without having to pay tax on it, so there’s some good news. 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 this money with other taxed income, could be a better idea. It could help dip you below one of the income tax thresholds, lowering your tax rate.

Another good thing about leaving more tax-free cash in the pension pot, is that it can remain invested, and could continue to increase in value. And this means any future 25% tax-free element could also grow. However the value of investments, and the income from them, may fall as well as rise and cannot be guaranteed and the investor might not get back their initial investment.

Tailor all your income to the tax thresholds

This strategy of spreading out your income across different tax years to keep your income beneath the allowances and thresholds, applies to all your income, not just pensions. HMRC will want to you tot up everything you receive to determine your taxable income and tax rate. This includes workplace pensions, annuities, any income from savings and investments, and any work you may still dabble in. Even your Basic State Pension or New State Pension is taxed before it’s paid to you. Lots of state benefits are taxable too, such as carer’s allowance.

For those of you who aren’t oligarchs or billionaires, it’s likely your income will go down in retirement. Which is all the more reason to keep as much of it as possible. Having a lower income also reduces your tax bill, so it’s not all bad.

In terms of income tax, and for most of the UK, currently the first £12,500 of your annual income is tax free. Then any amount over that up to £50,000 is taxed at 20%. Then any amount over £50,000 up to £150,000 is taxed at 40%. Finally any amount over £150,000 is taxed at 45% [3].

Note that tax rates and bands are different if you live in Scotland.

There are many different assets that can support retirement income. A good adviser will look at everything you have and help you plan how to use it astutely.

Look for tax-free income

The personal savings allowance means you can receive interest payments, up to specified levels, tax-free. Even if your income is between £50,000 to £150,000 you can still receive £500 in savings interest each year without paying tax on it.

If you have shares, you can earn £2,000 in tax-free dividend income each year. Above that you’ll pay a percentage of your earnings 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, PEP or pension. For 2019/20 the tax-free allowance is £12,000 [4].

Everything you’ve saved or invested in a cash ISA or stocks and shares ISA comes out tax free.

Share with your partner

If you’re married or civil partnered, spread your income and savings between you, to make the most of your tax-free allowances.

Include inheritance tax in the equation

Keep in mind that ISAs and other investments will be captured by inheritance tax, unless you’re passing assets to a spouse or civil partner. Thanks to new rules, funds inherited from your pension aren’t usually liable for inheritance tax, if you die before age 75 [5].

You may, for example, want to withdraw cash from other sources, within your nil-rate band of income tax, rather than from your remaining pension pot. As a general guide: if you’re facing income shortfalls you could prioritise using cash, then investments, then pensions.

It can be a delicate balancing act to maximise your retirement income and tax savings. A financial adviser could create a tailored retirement income plan, based on a full understanding of external factors, and your situation.

Sources

[1] https://www.pensionspolicyinstitute.org.uk/media/2842/201810-bn109-erl-tax-and-benefits-final.pdf page 9

[2] https://www.gov.uk/income-tax-rates (2019/20 tax year)

[3] https://www.gov.uk/income-tax-rates (2019/20 tax year)

[4] https://www.gov.uk/capital-gains-tax/allowances (2019/20 tax year)

[5] https://www.gov.uk/tax-on-pension-death-benefits