Top tax tips for retirement
How to save on the tax you pay before and during retirement
When it comes to the thought of retirement, probably the last word that creeps into our mind is “tax”. Why should it? Retirement is a time to think about all of the things that you have always wanted to do with the money you have worked hard to earn.
However, the unfortunate truth about retirement is that there may still be tax to pay. Fortunately, with proactive financial planning you can help minimise the tax that you pay during retirement.
Understanding your tax threshold in retirement
During retirement it’s likely that you will start drawing an income from various sources. Like any income that you were drawing whilst employed, retirement income may still be subject to income tax. In the UK everyone has a Personal Allowance, meaning that you do not pay tax on the first £12,500 (tax year 2020/21).
Most income above the Personal Allowance is subject to income tax at 20%, rising to 40% above £50,000 and 45% above £150,000. Therefore, it’s usually a good step to understand what tax band you may fall into during retirement, and whether any income that you have earmarked may take you above any given band.
How are different sources of income taxed?
The term “cash is king” may seem a little exaggerated given the extremely low interest rate environment that we are currently living in, but drawing on your available cash reserves can be a tax efficient way of generating a retirement income. The reason why drawing cash could be a way to save tax is that most withdrawals that you make from a bank account or building society are tax free, provided that any interest that you have earned on your savings does not exceed the Personal Savings Allowance.
The Personal Savings Allowance (PSA) entitles you to £1,000 tax free interest if you are a basic-rate taxpayer and £500 tax-free interest if you are a higher rate taxpayer. Any interest that you earn as an additional rate taxpayer is taxable. If you are an additional rate taxpayer, or you believe that any interest that you earn may be above your PSA then you could consider a Cash ISA as a home for your savings, if you are not using your ISA allowance elsewhere.
Investment income can be taxed in slightly different ways depending what income tax band you fall into and what type of income it is (e.g. dividends or interest) However, one way that you can avoid an unnecessary headache of tax being taken on your investments is to consider a Stocks & Shares ISA.
Many people in the UK have a Stocks & Shares ISA as a home for their investments. The obvious reasons for doing so is that they provide you with great access to a range of stocks and investment funds, and you can contribute up to the ISA allowance each year, which is currently £20,000. This is the amount that you are allowed to contribute in total per year – so be aware if you also pay into a Cash ISA or Lifetime ISA as well.
Stocks & Shares ISAs are also hugely beneficial from a tax perspective as any capital gains, interest or dividends that you earn on your investments are free from tax. Any withdrawals from Stocks & Shares ISAs are also free from tax, contrary to pensions, which we will move on to a little later.
Overall, if you are holding investments, it’s often recommended that you hold these within a Stocks & Shares ISA in order to minimise the tax that you might pay.
Contrary to money drawn from an ISA, money drawn from a pension may be liable to income tax. The tax that you may pay on your pension depends on a broad range of factors. You first need to identify the type of pension scheme that you are enrolled in, and then you’ll need to establish what options you have available to you in accessing your benefits and determining ways to reduce the tax you might pay.
If you have a Defined Benefit scheme, sometimes referred to as a Final Salary pension, they typically provide you with a fixed level of income for the rest of your life. As you might expect, if you are receiving a fixed level of income each year then there isn’t much wiggle room if you want to reduce your income tax bill. You could therefore consider drawing on cash or investments as a source of more tax-efficient income.
In comparison, if you have a Defined Contribution pension there may be several ways that you can draw an income from your pot, but each have different tax consequences. Some pensions offer the full range of options in accessing your pension, but some schemes do not. If your scheme does not offer the full range of options in accessing your pension benefits it could result in you pay too much tax during retirement.
Despite the differences between Defined Benefit Schemes and Defined Contribution Schemes there is normally one similarity between the two, and that is the ability to take a tax-free lump sum from your pension. Current legislation permits that for individuals in a Defined Contribution Scheme, 25% of the total value of your pension can be drawn as a tax-free lump sum. For a Defined Benefit Scheme that is broadly the same, but depends on the scheme’s own calculations. Naturally, taking a tax-free lump sum from a pension is a great way of saving tax (as the name suggests), but you could potentially save even more tax if you take a lump sum and combine it with taking a regular income from your pension. For example: It is not uncommon for individuals to take a tax-free lump sum from their pension, as well as drawing an income from their pension that keeps them below the Personal Allowance threshold of £12,500. The end result could be no tax liability at all, depending on what other assets you draw on.
Our ultimate tips here are to firstly find out what type of scheme you are in. Then secondly, to understand how you can draw an income from your pensions. Finding out all the options will help you decide when you should be drawing on your pensions in conjunction with your other assets in order to minimise the tax you might pay.
Finally, no discussion about retirement income could be complete without stressing the importance of the State Pension. For most people, the current State Pension will be paid from age 67 (which is expected to rise to 68 in 2037 - 39) – this has gradually been increasing over the last few years. But it can provide a generous source of retirement income to help you meet your expenditure. However, it’s important to stress that coupled with any other income that you are receiving, the State Pension could push you into a higher income tax band.
Our tip here would be to check what other income you may draw upon when your State Pension kicks in. Having an idea of what other income sources you are drawing upon in conjunction with your State Pension, will then help you understand whether you could draw from a more tax efficient source later in life, such as savings or investments.
Devising a plan
At The Private Office (TPO) we have vast experience in designing financial plans for our clients. Central to any financial plan is ensuring that you maximise your wealth to achieve your goals. We have a dedicated team who specialise in retirement planning and ensuring that your wealth works as hard as possible for you and that you are minimising tax where possible during this next stage of your life.
If you are looking for help and advice regarding your own personal finances in these uncertain times, we are offering anyone with £100,000 or more in savings, investments or pensions a FREE consultation. Why not get in touch and speak to an adviser.