The income tap

With tax-free allowances totalling £26,700 for income and capital gains each year, planning retirement income need not be taxing at all. But to get the most out of retirement savings, it takes the right mix of tax wrappers and advice about which wrappers to take income from, and which will provide the greatest inheritance for loved ones.

2015/16 Tax allowances

The personal income tax allowance is set to increase to £10,600 from April. In addition, it will be possible to take a further £5,000 savings income tax-free. There is also the annual capital gains tax exemption, which will stand at £11,100.

This makes a total of £26,700 of income and capital gains each year which can be taken tax-free by just making full use of the available exemptions. But if retirement income is being provided from the pension alone, then £16,100 worth of tax allowances could be missed. That is because the savings band begins to be removed once earned income – including pension income – exceeds the personal allowance.

Multi-investment retirement planning

To make the most of these allowances, it pays to have saved across a range of different investment tax wrappers after maxing out your pension and Isa. Each tax wrapper has its own particular tax characteristics. Having a combination of these can provide flexible tax-efficient income and estate planning solutions.

The ability to turn income up and down like a tap as required can be the key to opening up tax-efficient income in retirement. For example, stopping pension income for a particular tax year and replacing it by taking withdrawals from other investments can reduce the overall tax payable by using tax allowances.

Pensions

Remember it is only those with fully flexible DC pensions who will have this income freedom to manipulate the level of income each tax year, made up of any combination of income and/or tax-free cash.

It will not be possible to turn on and income from state pension, DB pensions, scheme pensions or conventional annuities like a tap.

Paying less tax on retirement income will mean the funds will last longer – assuming the same investment growth – leaving more wealth to pass on to loved ones.

Unlike most other assets, pension funds are rarely subject to inheritance tax. The new death benefit rules scrap the 55 per cent tax charge on drawdown lump sum death benefits. Each beneficiary will have exactly the same death benefit options from their inherited fund, allowing pension wealth to cascade down several generations while continuing to enjoy the tax freedoms that the pension wrapper will provide.

This could see a u-turn in strategy for anyone whose primary concern is maximising what can be passed on. The previous wisdom of stripping out funds and gifting the surplus income to minimise the impact of the 55 per cent tax charge has given way to retaining funds within the pension as a more tax-efficient solution.

Isas

Isas are probably the simplest wrapper to understand. With Isas there is no income tax or CGT when income or funds are withdrawn, plus funds grow free of tax, making them a popular investment choice. However, on death, Isa funds will form part of the estate, potentially leaving only 60 per cent of the fund inheritable.

Unit trusts and Oeics

Income from unit trusts and Oeics remains taxable whether it is taken or reinvested, regardless of whether this is through investing in accumulation units or purchasing fresh units each time.

Any capital withdrawn will be a disposal for CGT, provided gains do not exceed the annual exemption (£11,100 in 2015/16). And of course, that is just the amount of gain that can be withdrawn tax-free. Withdrawals will also include a return of the original capital which is not taxed. These investments also form part of the estate, but withdrawing funds to meet income also reduces the potential IHT bill.

Offshore bonds

Investment bonds are unique in that income and gains are rolled up – gross in the case of offshore bonds – within the fund, and only become taxable when a withdrawal triggers a chargeable gain. Further, withdrawals of up to 5 per cent of the original capital can be taken without an immediate tax charge.

This ability to defer and control when income becomes taxable is a valuable tool for tax planning. Timing withdrawals to coincide with tax years when there is little or no other income can result in gains falling within the personal allowance and savings rate band, meaning no tax is payable. Again, only the investment growth is taxable, not the return of the original capital.

Another useful planning feature is the ability to assign the bond or segments without triggering a tax charge. The new owner then becomes assessable to future tax. And with offshore bond gains taxed as savings income, a non-taxpayer could have gains of up to £15,600 completely tax-free, thanks to the changes to the savings rate band from April.

Onshore bonds

Onshore bonds enjoy many of the same planning freedoms as offshore bonds. But the key difference is that the onshore bond fund pays UK corporation tax on capital gains and interest, with a non-reclaimable 20 per cent credit given on surrender for the tax paid within the fund. As a result, onshore bonds sit on top of all other income in the order of taxation and non-taxpayers can not benefit from the additional £5,000 tax-free allowance.

Devising a combined income solution

While this mix of tax treatments can be confusing for investors, it offers real tax planning opportunities. Matching the income characteristics from each wrapper to the available allowances and preserving the capital for future generations is where those opportunities lie. Of course, as we all know, tax rules may change in the future, and investment growth is not guaranteed.

Dave Downie is technical manager at Standard Life

Key Points

The new pension flexibility could see conventional wisdom on retirement income planning flipped on its head.

Tax-efficient retirement income can be enabled by turning income up and down as required.

With investment bonds, income and gains only become taxable when a withdrawal triggers a chargeable gain.