Retired clients could be wasting up to £16,100 of tax free allowances each year by taking their retirement income solely from their pension. And at the same time they could be reducing how much wealth could be left to their loved ones on death.
The challenge is to undo a lifetime’s worth of hardwired retirement savings habits. And the key to achieving this is to demonstrate that an alternative retirement income strategy using a range of tax wrappers can provide a sustainable source of spendable income while securing the best possible legacy on death from unused funds.
To achieve this will require:
- Breaking the instinctive link between retirement income and pensions – for over 55s it’s just like any other savings pot.
- Avoiding paying unnecessary tax by maximising available allowances – take income for taxable sources within the available allowances.
- Annually reviewing income needs to get the balance right – this isn’t a one off retirement income decision.
- Preserving tax privileged savings for longest – less tax not only means funds will generally last longer but there’s also likely to be more to leave behind.
- General rule of thumb for taking income – first, offshore bonds & OEICs, second, ISAs and leave pension until last.
Pensions and retirement income are synonymous with one another. The first thing most clients will think about when considering their income in retirement will be their pension. But with the new pension freedoms it isn’t necessarily the first place they should turn to when deciding where to draw their retirement income from.
It is now time to start thinking of savings collectively rather than as separate individual pots. Clients with savings across a variety of wrappers need to consider the best way to access these to meet their income needs in retirement. The familiar scenario of using the pension to provide income needs and other savings earmarked for other purposes, perhaps as a future inheritance for the kids or as a rainy day fund, requires a rethink.
It’s important to look at the long term goal when deciding which investment to take income from in retirement. Getting as much in by utilising the reliefs available, and paying less tax by maximising the use of available allowances, can mean that savings are preserved for longer. This will generally result in a more sustainable income stream and it can also lead to a potentially greater inheritance for the client’s family.
Tax efficient income-lets have a look
It pays to make use of the available tax allowances when structuring retirement income. Up to £26,700 of income and capital gains can be taken tax free this year. For a retired couple that’s £53,400 a year without a penny in tax.
The personal income tax allowance increased to £10,600 from April. In addition, it is now possible to take a further £5,000 savings income tax free. Then, of course, there’s the annual CGT exemption which stands at £11,100.
The order in which funds are withdrawn in retirement can have significant impact on the tax allowances available and ultimately how much tax is payable. For example, the £5,000 tax-free savings rate band is lost if income from pensions exceeds £15,600.
Limiting the amount of tax paid on retirement income is one part of the equation. In some cases there may be more than one way to obtain a tax efficient retirement income from the funds available.
1= Offshore bonds
Gains from offshore bonds are treated as savings income. For someone who has no earned income (including pension income) gains of up to £15,600 can be withdrawn without incurring an income tax charge. So it makes sense to strip out offshore bond gains before starting to take pension income especially if the gains can be kept within the new tax free starting rate band.
In addition offshore bonds will typically form part of the estate on death. Using these funds for income in retirement could reduce the potential IHT for those clients with estates in excess of their available nil rate band.
1= Unit trusts/OEICs
Using withdrawals from a unit trust or OEIC to meet retirement income needs will result in a capital gain rather than an income tax liability. If the gain can be managed within the £11,100 annual CGT allowance then withdrawals will be tax free. Gains in excess of the allowance will be taxed at either 18% (if they fall within the basic rate tax band) or 28% if above the threshold.
Unit trusts and OEICs will also form part of the estate. Again withdrawing funds from these could potentially reduce how much IHT is due upon the estate.
Keeping savings in a tax friendly wrapper such as an ISA makes sense. So typically it will be worth withdrawing other taxed funds up to the available allowances before touching the ISA.
But those concerned about leaving a legacy for their loved ones will need to remember that the ISA will form part of their estate for IHT.
The new pension freedoms have turned conventional retirement income planning on its head. No longer should pension savings be the first thing clients turn to provide their income in retirement. Any clients with other savings in addition to their pension may be advised to withdraw income from other sources first and leave their pension until last.
The funds within the pension enjoy the same tax free gross roll up as the ISA. But, unlike other investments, pension savings are generally free of IHT. And the new death benefit rules provide greater choice on who and how pension wealth can be inherited.
The taxation of pension death benefits has changed for the better too. If a client dies pre 75 their pension can be passed on tax free. Post 75 their beneficiary will be able to draw an income which will be taxed at their marginal rate.
Having a range of different investment wrappers will increase the scope to utilise the tax free allowances. But that doesn’t necessarily mean spreading savings across wrappers is always the right thing to do. Paying little or no tax on savings is appealing but a pension contribution with tax relief and 25% tax free cash could still provide more in the pocket even after paying some tax on the income.
Pensions now enjoy such a privileged tax status that they should now be the first choice for life savings and the thing to keep hold of longest in retirement. The advantage they now hold over other investments means that it is worth considering wherever possible moving a client’s other savings into their pension in the run up to retirement.