Retirement Income Planning – beat the tax with a range of investments
The new income flexibility and greater inheritability of pension wealth could see conventional wisdom on retirement income planning flipped on its head. From April, it could pay to retain pension savings within your pension and take income from other investments first.
With tax free allowances totalling £26,600 for income and capital gains each year, retirement income needn’t be taxing at all. But to get the most out of your retirement savings, it needs the right mix of tax wrappers and good advice on which investment to take your income from and which will provide the greatest inheritance for your family.
Stripping out is out-stripped by the tax charges
Much of the talk post Budget focused on the fact that unrestricted access to a lifetime’s pension savings could be a temptation too far for some. But at what cost?
Stripping out your pension fund in one go will mean an entire retirement’s worth of income tax liability is shoe-horned into a single tax year. Tax allowances may be wasted and it could result in an income tax bill which is potentially higher than the tax relief you received on your contributions. Plus it brings the value of the pension back into your estate for Inheritance Tax (IHT).
2015/16 Tax allowances
The personal income tax allowance is set to increase to £10,500 from next April. In addition, it will be possible to take a further £5,000 savings income tax free. Then, of course, there’s the annual Capital Gains Tax (CGT) exemption which will stand £11,100.
So that’s a total of £26,600 of income and capital gains each year which can be taken tax free by just making full use of the available exemptions. But if retirement income is being provided from your pension alone, then £16,100 worth of tax allowances could be missed. That’s because the savings band begins to be removed once earned income (which would include your pension income) exceeds your personal allowance. And with the annual CGT exemption, it’s a case of ‘use it or lose it’.
It’s also important to look at what will be available to family members on death and that means paying attention to IHT and, in particular, the new pension death benefit rules.
Multi-investment retirement planning
To make the most of these allowances, it pays to have saved across a range of different investment types after maxing out your pension and ISA. Each investment has its own particular tax characteristics. Having a combination of these can provide flexible tax efficient income and estate planning solutions.
The ability to turn income up and down as required can be the key to opening up tax efficient income in retirement. For example, stopping pension income for a particular tax year and replacing it by taking withdrawals from other investments, can reduce the overall tax payable by utilising tax allowances which, in turn, can lead to reduced rates of tax.
Remember it’s only fully flexible DC pensions which will have this income freedom to manipulate the level of income each tax year – made up of any combination of income and/or tax free cash.
It won’t be possible to turn on and off income from State pension, DB pensions, scheme pensions or conventional annuities like a tap. This could mean using the years before these fixed retirement incomes commence as a window of opportunity to take income from other investments tax efficiently. There may even be value in considering the merits of deferring these incomes and taking withdrawals from other assets as a sort of bridging pension.
And paying less tax on retirement income will mean your funds will last longer (assuming the same investment growth) and more wealth to pass on your family members in the event of death.
Unlike most other assets, pension funds are rarely subject to IHT. The new death benefit rules scrap the 55% tax charge on drawdown lump sum death benefits. And each beneficiary will have exactly the same death benefit options from their inherited fund, allowing pension wealth to be cascaded down several generations whilst continuing to enjoy the tax freedoms that the pension provides.
But it’s important to understand what death benefit options your current schemes will be able to offer. Not all schemes will be in a position to support the new freedoms. And where death benefit flexibility is high on your list of priorities, it may be necessary to seek advice on transferring before it’s too late.
This could see a u-turn in strategy for anyone whose primary concern is maximising what can be passed on. The previous wisdom of stripping out funds and gifting the surplus income to minimise the impact of the 55% tax charge, has given way to retaining funds within the pension as a more tax efficient solution.
ISAs are probably the simplest wrapper to understand. There’s no income tax or CGT when income or funds are withdrawn. Combined with the fact that funds grow free of tax means that they’re a popular investment choice.
However, on death, ISA funds will form part of your estate and, where IHT is payable, it leaves only 60% of the fund inheritable.
Unit Trusts & OEICs
Income from unit trusts and OEICs remains taxable whether it’s taken or reinvested, regardless of whether this is through investing in accumulation units or purchasing fresh units each time. The mix underlying assets in the fund will determine whether income is paid as interest or as a dividend.
Any capital withdrawn will be a disposal for CGT. Provided that gains don’t exceed your annual exemption (£11,100 2015/16) there will be no tax payable. And of course, that’s just the amount of gain that can be withdrawn tax free. Withdrawals will also include a return of your original capital which is not taxed. So for example, if the value of the units has increased by 50% then the total amount that can be withdrawn tax free would be £33,300 (£22,200 original capital and £11,100 capital gain) if you have a full annual allowance available.
Unit trust and OEIC portfolio will form part of the estate and by withdrawing funds to meet income, it’s also reducing your potential IHT bill.
Investment bonds are unique in that both income and gains are rolled up (gross in the case of offshore bonds) within the fund and only become taxable when a withdrawal triggers a chargeable gain. In addition, withdrawals of up to 5% of the original capital can be taken without an immediate tax charge.
This ability to defer and control when income becomes taxable is a valuable tool for tax planning. Timing withdrawals to coincide with tax years when there’s little or no other income can result in gains falling within the personal allowance and savings rate band, meaning no tax is payable.
Like unit trusts and OEICs, only the investment growth will be taxable, not the return of the original capital.
Another useful planning feature for bonds is the ability to assign (give away) the bond or segments without triggering a tax charge. The new owner, who perhaps might be a non-taxpayer, then becomes assessable to future tax.
And with offshore bond gains taxed as savings income, a non-taxpayer could have gains of up to £15,500 which are completely tax free, thanks to the changes to the savings rate band from next April.
Onshore bonds enjoy many of the same planning freedoms as offshore bonds. But the key difference is that the onshore bond fund pays UK corporation tax on capital gains and interest, with a non-reclaimable credit given on surrender for the tax paid within the fund at 20%. As a result, onshore bonds sit on top of all other income in the order of taxation and non-taxpayers can’t benefit from the extended £15,500 tax free allowance.
Devising a combined income solution
This mix of tax treatments can be confusing, but it offers real tax planning opportunities.
There’s no one size fits all solution and everyone’s circumstances will be different. It’s essential that you seek advice so that any solution is tailored to fit your aims and objectives to get the best tax outcome. For some, this could even mean that life after work could be life after tax.
David Downie DipPFS STEP Affiliate
Technical Consultancy Manager, Technical Consulting, Standard Life
This article is for information only and does not constitute advice. Please obtain professional advice before making financial decisions. The views contained in this article are those of Brooks Macdonald and not necessarily those of Wren Sterling.
All information is correct at time of writing (November 26 2014).