Tax when selecting a retirement income option

The many different options to fund retirement in addition to pensions all have different tax consequences, Claire Trott, head of technical support at Talbot & Muir, agrees.

She says it is important to not just compare the growth or income you could receive from the various different retirement income options, but also the impact it may have on other parts of the financial strategy and taxation of other assets that the individual may hold.

“Retirement income from one source should never be considered in isolation. The whole finance health of the individual will have an impact on the decision to transfer, not just the single pot and what they could do with it.”

Rod McKie, head of retirement propositions at Zurich Life, says considerations are intuitively around income tax and ensuring that income withdrawals are taken from the most tax advantageous source.

Mr McKie says: “The best solution for a customer will be specific to their situation and circumstances and this is where advice can really help customers achieve the best outcome they can.”

Income planning

Billy Burrows, director of Retirement Intelligence, says tax efficient income planning is vital to at-retirement advice, adding people should “look at net income not gross.”

One way advisers can really prove their value is in minimising their client’s income tax liability.

For example, Jamie Jenkins, head of pensions strategy at Standard Life, points out someone with a £100,000 pot who decides to take out their entire pension in one go, would pay tax on £75,000 of that pot.

Even if we assume they have no other income source, Mr Jenkins says they will still pay higher rate tax on a substantial part of that money.

However, if they were to spread taking their income out over a number of tax years, they would reduce their liability significantly and, if they kept what they withdrew within their personal allowance in each year, then no tax would be due.

James McLeod, head of pensions at AES International, says if income can be distributed between husband/wife/partner, then this can be beneficial to ensure the maximum available income after tax.

Ultimately the reality is the best way to pay no tax is to have no income or capital gains but most of us need to live on something, David Trenner, technical director of Glasgow-based IFA Intelligent Pensions, points out.

Mr Trenner says ‘cashing in’ a pension fund to invest the net proceeds is simply stupid because in the pension fund growth is tax free and benefits include 25 per cent tax free cash.

If you take more than £100,000 income from your pension, Mr Trenner points out you will lose part or all of your personal allowance and then your investment returns will be taxed at 40 per cent or even 45 per cent.

Taking instalments of tax-free cash as part of a phased drawdown (or phased annuitisation) strategy could save income tax, but Mr Trenner says this does not work if you need cash to clear debt or to buy a car to replace your company car when you retire.

Death taxes

Mr McKie says thought should also be given around inheritance tax planning and the favourable treatment of pension assets before the age of 75 sitting outside of a customer’s estate.

By a strange quirk of George Osborne’s logic, Mr Trenner says a widow’s pension from a defined benefit scheme is taxable but from a personal pension it is only taxed if death occurs after 75.

Under the new rules, all defined contribution pensions are no longer subject to the 55 per cent ‘death charge’.

Where death occurs after age 75 a 45 per cent tax applies to lump sum withdrawals, while income is taxed at the beneficiary’s marginal rate. It is intended all withdrawals will eventually be taxed at the marginal rate. Where death occurs after 75, all withdrawals by the beneficiary are tax free.

Some, including government older workers Tsar Ros Altmann, have said the new rules mean a pension should be saved and other sources used to provide an income in retirement, as the pension has become the most effective inheritance vehicle.

Mr Jenkins agrees and says with the ability now to leave a pension pot to your nearest and dearest income-tax free on death before age 75, taking out income while alive which will be taxed makes the retirement income option decision more difficult.