Careful planning of drawdown income can yield more than tax-efficient income.
Investors are likely to receive income from multiple sources in retirement, including the gross interest gained from savings accounts, dividend income from shares, property, and certain state benefits.
Understanding how income taken out of a pension will interact can be complex.
More of the pension can remain invested by withdrawing only what is necessary, increasing the chances of the fund lasting for longer in the tax-privileged environment and maximising the value that may ultimately be passed on to beneficiaries without further tax deducted.
On deciding to enter drawdown, an investor is able to take 25 per cent of the fund as a tax-free lump sum, but any income taken in addition to this is subject to income tax, along with other taxable income.
It is important the pension provider is in possession of the correct tax code to ensure the right amount of tax is deducted. This will avoid excessive upfront tax deductions and having to request a refund.
Since April 2015, the pension freedoms afford investors greater flexibility. It may be preferable to take the entire tax-free lump sum up front depending on individual situations, such as when a larger amount is required to repay debts.
Alternatively, an investor may want to ensure 25 per cent of each income payment is tax-free by phasing the crystallisation of a fund.
Taking a portion of the tax-free cash with each income payment can reduce the amount of income tax paid on withdrawals.
An effective withdrawal strategy will need to consider the allowances available to the investor.
A large withdrawal should be avoided in a single tax year as this could lead to higher-rate tax deductions. If a large sum is required, then phasing withdrawals from the plan across a number of years is likely to be more tax efficient, by reducing the chance that an investor’s total income will be subject to higher income tax deductions.
Other sources of income and capital should be considered, especially where withdrawals can be made without any tax deduction, such as from an Isa.
If an investor has direct holdings in collectives or individual shares, then divesting these to meet retirement income can potentially utilise their annual capital gains tax allowance, currently worth £11,100.
This may also be prudent from an inheritance tax perspective, as assets such as these are likely to form part of the estate on death.
If higher withdrawals are required, then investors should be made aware that their personal allowances are reduced once their annual incomes exceed £100,000. This results in an effective income tax rate of 60 per cent where total income for the year is between £100,001 and £121,200. At this point, every £1 of net income costs the member £2.50.
Once withdrawals exceed the additional rate threshold (£150,000), the investor would still need to withdraw £1.83 in order to receive £1 of net income.
Since April there has been a dramatic rise in the number of investors withdrawing monies from their pensions as they take advantage of the new freedoms.
The other beneficiary of these withdrawals has been the architect of these very freedoms – the chancellor of the exchequer.
Income tax receipts have risen far beyond the original estimates, and much of that could have been avoided with more careful planning.
Managing income during retirement can be complex, especially where there are many potential income sources.
Paul Evans is pensions technical manager at Suffolk Life
