Using all available tax allowances is key to maximising tax efficiency in retirement.
Pensions are the most popular method of saving for retirement whether that be via employment or a personal arrangement. Contributions attract tax relief and the fund grows tax efficiently. But what about when we come to draw our pension benefits?
As we know, usually 25% of the fund can be taken as the pension commencement lump sum (PCLS or ‘tax-free cash’), with the remainder being liable to income tax, just like employment income. The current personal allowance for income tax is £12,500 per annum, and if you were in receipt of the full state pension of £8,767 you could draw a further £3,733 from a pension fund without paying tax. But what other products and tax allowances could help fund retirement?
UK adults can invest up to £20,000 per annum into ISAs, whether stocks and shares or cash. Any withdrawals are completely tax free with no limits on how much you can withdraw. Collective investments, such as unit trusts (outside of an ISA wrapper), can be invested in when the ISA allowance has been used up, but withdrawals may be subject to capital gains tax. However, we each have an annual capital gains tax allowance, currently £12,000, within which withdrawals can be managed to take advantage of any capital gains. Any gains above this level are only taxed at 10%, or 20% for a higher rate taxpayer, which is much less than the respective income tax rates.
We currently have a £2,000 dividend allowance that could generate an income derived from shares or collectives that pay regular dividends. A basic rate taxpayer also gets a personal savings allowance of £1,000 (£500 for higher rate tax payers and nil for additional rate) for savings income, ideal for deposit-based investments such as National Savings, which can provide a regular income.
Investment bonds can also provide a tax-deferred withdrawal of 5% of the original investment per year. If this limit isn’t exceeded, it can provide immediate tax-deferred withdrawals regardless of your tax position, and there is no liability to capital gains tax. There are however certain other events where a tax charge may occur and tax advice would need to be sought.
Further up the risk spectrum come venture capital trusts (VCTs), enterprise investment schemes (EISs) and seed EIS schemes (SEIS). In addition to providing income tax and inheritance tax benefits, dividends paid from VCTs are free from any additional tax in the hands of an investor.
Property rental income can also provide a reasonably steady and secure income on long-term leases and is assessed as income tax.
Pension freedoms changes mean that benefits can now be accessed in a much more flexible manner, such that income withdrawals can be managed to use up income tax allowances, or to stay within a certain tax rate, depending on your requirements.
Pensions are a very important and useful part of retirement planning, but additionally, by building up additional savings vehicles throughout your working life, you can maximise the tax efficiency of withdrawals during retirement. After all, we pay enough tax over our lifetime; why keep doing it in retirement?
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