How to minimise tax at retirement

With careful planning, it’s possible to pay little or no tax when you come to retire. Jonathan Watts-Lay outlines three examples to show you how.

People could end up paying 200 times more tax, depending on how they decide to access their retirement income, according to research by the Pension Policy Institute (PPI).

The findings were based on the tax that someone would pay if they fully withdrew their defined contrition (DC) pension, compared with annuity purchase.

The PPI also reported that HM Revenue & Customs could see increased tax revenue of around £19.2 billion over the next 10 years, based on the way people have accessed their savings since pension freedoms were introduced in 2015.

The choices individuals make at retirement can make a big difference to the amount of income they end up with. Those with defined contribution (DC) savings can choose between income drawdown, buying an annuity or taking a cash lump sum.

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What must be remembered is that while generally 25% of a DC pension can be taken tax-free, the remaining 75% is taxed as earned income. However, by utilising the tax allowances and reliefs available, they could potentially reduce or even eliminate future tax charges on their retirement income.

To illustrate this, financial education specialist WEALTH at work has created three examples that demonstrate how people can look holistically at all their savings and investments to create the most tax-efficient retirement income and, in some cases, pay very little tax.

All the examples outlined below involve similar situations, but examples one and three are not yet eligible for state pension, and example three has a smaller pension pot with more taxable savings. All examples assume stocks and shares Isa returns of 5% and interest available on taxable cash deposits of 1.4% gross.

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1 Peter

Peter is aged 60. He has a final salary pension which will pay £8,350 a year, a DC pension fund worth £300,000, stocks and shares Isas worth £50,000, and £10,000 held in cash.

He is planning to retire in April 2019 and would like to generate an initial annual income of £20,000 a year net and retain the £10,000 as an emergency cash reserve.

By utilising his Isa and taking income through his pensions, it is possible for him to do this without paying any tax in year one (even though £20,000 is almost double the personal allowance of £11,850 for 2018/19).

Peter can draw the £2,500 (5%) return from his Isa, leaving £17,500 to find. He has a personal allowance of £11,850, so he does not need to pay tax on the £8,350 from his final salary pension and will have a further £3,500 of unused allowance available.

He therefore needs a further £9,150 to achieve the £20,000 income he is looking for. He could take benefits on £22,600 of his DC pension, taking 25% tax-free (£5,650) and then drawing £3,500 as income from the £16,950 available. By doing this he will have the £20,000 he is looking for, tax-free. 

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2 Mary

Mary is in exactly the same financial position as Peter, but is eligible for the full new state pension.

As the combined income from her final salary scheme and state pension will be higher than the personal allowance, she will need to pay some tax, but will not need to pay any further tax up to the £20,000 annual income she is hoping for.

Mary has a personal allowance of £11,850. The combined income of £8,350 from her final salary pension plus £8,296 new State Pension gives her a gross income of £16,646. Income tax payable on this would be £959, leaving a net income of £15,687.

To achieve an income of £20,000 a year, she could supplement this with the £2,500 return from her stocks and shares Isa and £1,813 tax-free cash from her DC pension fund.

To do this she will need to draw benefits on £7,252 from her DC pension; £1,813 (25%) can be taken as a tax-free cash lump sum, but the remaining £6,489 can remain in her pension fund with the potential to grow.

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3 David

David, aged 60, is also looking to retire in April 2019. He is not yet eligible for his state pension; his DC pension is £200,000 and he has taxable cash deposits of £100,000 as well as an Isa of £50,000.

To achieve an income of £20,000 a year tax-free, he can use the £8,350 from his final salary pension and £3,500 from the taxable part of his DC pension fund to use up his personal allowance (£11,850). He needs to withdraw £4,667 of his DC pension, with £3,500 (75%) in taxable income and £1,167 (25%) paid as a tax-free cash lump sum (£3,500 + £1,167 = £4,667).

This can be supplemented with £1,400 interest from his savings (£100,000 at 1.4%), which will not be taxed because the starting rate for savings income is £5,000. 

As it is better to leave as much money as possible in the tax-efficient wrappers of Isa and pension, David may choose to withdraw the remaining £5,583 needed from his cash deposit to make up the £20,000 he is looking for.

With all these examples, the individuals are paying the lowest possible amount of tax, keeping their Isas at the same level and withdrawing the remaining amount needed in a tax-efficient manner from their pensions and other savings and investments.

Jonathan Watts-Lay is director of WEALTH at work.