By Fiona Tait, Technical Director, Intelligent Pensions
Pensions have three great things going for them as a retirement saving vehicle. The first is that any contributions receive tax relief up front which provides an immediate return on investment. The second, although many people do not appreciate it, is that they cannot be spent too soon, and the third is that there is a tax ‘brake’ on how much is spent when access is permitted. These three things together mean that putting money into a pension and leaving it there is extremely tax-efficient.
This is all very good, but it means that although pensions are first and foremost intended to provide income in retirement, they are not always the best vehicle to actually do this. When it comes to withdrawing an income, there is a distinct order of encashment which makes better use of the tax allowances available than just simply taking it from the pension plan.
1. Pensions – PCLS
Once an individual reaches age 55 it is possible to withdraw a proportion of their pension completely tax-free - the Pensions Commencement Lump Sum (PCLS). The amount available is usually up to 25% of the fund value in a Defined Contribution (DC) pension however, it is worth checking if any pre-simplification protections apply. Flexible pension arrangements – drawdown – allow this amount to be taken up front and it could then be used to cover income needs in the early years of retirement.
Alternatively, the tax-free PCLS could be used to reduce the income tax due in each year, via phased retirement or a series of Uncrystallised Fund Pension Lump Sums (UFPLS). This may be suitable for people who remain in the higher and additional rate tax bracket after retirement, but it would trigger the Money Purchase Annual Allowance (MPAA) which would restrict future saving, and of course 75% of each payment would still be subject to income tax.
If, however, the primary concern is to minimise the tax bill, the latter issue could be dealt with by restricting income withdrawals to within the Personal Allowance of £12,570, assuming there is no other income to take into account and meeting any additional needs by cashing in non-pension investments.
2. ISAs
Unlike pensions, withdrawals from ISAs are not subject to either income or capital gains tax (CGT). Individuals who have built up ISA savings over the years could therefore significantly reduce their tax bill by running down their ISA pot before their pension. This is even more efficient as any ISA savings left after the holder’s death would form part of their estate, while pension funds would not. Another tax saving.
3. General Investment Accounts (GIAs), unit trusts and OEICs
Currently up to £12,300 may be withdrawn each year from capital investments without attracting a CGT charge, which may be used to provide a tax-free top up to other income sources, and it is also possible to utilise the £2,000 dividend allowance to make tax-free withdrawals from equities held within the fund. Depending on their current tax status, investors may also receive up to £1,000 within their Personal Savings Allowance from interest-based investments.
4. Investment bonds
Onshore bonds may be used to provide a tax-deferred income of up to 5% of the value invested over a 20 year period. It is of course important to remember that this income is tax-deferred rather than tax-free, and if any gains have been made, they will be taxed as soon as the 5% cumulation is exceeded. It could however be another useful way of supplementing income in the early years of retirement when individuals are more likely to be paying higher or additional rate tax.
5. Pensions again
Once all of these options have been fully utilised it is time to go back to pension savings again. It may seem counter-intuitive to leave them until last but the advantage of this approach is that the funds remain outside the estate as long as possible. Should the investor die before they reach age 75, any remaining funds would be passed on to their beneficiaries without being subject to Inheritance Tax (IHT). The situation should then be reviewed according to the individual’s personal situation, as beneficiaries would have to pay income tax on the death benefits. This may or may not be a higher amount than the IHT that would be due if the money is in the deceased’s estate.
So there you have it. It just remains to say that tax is not the only consideration. Some investments, such as property or property-based funds, may be difficult to cash in, and others may carry encashment penalties in the early years. But there really is no need to just stick to pension savings in retirement, unless of course that’s all you’ve got.
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