PensionsMay 29 2018

Maximising your retirement income

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Maximising your retirement income

Most people think about Isas and pensions in terms of the upfront benefits, but it is essential to think about tax-efficient savings in terms of when you want to access those funds as well. Being tax-efficient throughout your working life and then again in retirement will ensure that you are maximising your income and minimising your tax bills, but all in a fair manner and within the current guidelines.

With upfront tax relief, potential employer contributions, 25 per cent tax free cash, and inheritance tax (IHT) benefits, prioritising pensions over Isas seems an obvious choice for many investors. However, Isas do have their uses, particularly for investors who are basic rate taxpayers or for those who may encounter lifetime limit issues.

In addition, having a combination of both gives many options when it is time to take benefits, as the non-declarable nature of Isas means you can use them to supplement your income in a tax-efficient way, for example by avoiding going into higher-rate tax bands in retirement. Isas also have the advantage that if you do need to access funds in advance of your retirement, then drawing from your Isa is always an option.

For those unable to benefit from higher or additional rate tax relief, pension contributions are an obvious choice. A £60 net contribution for a higher-rate taxpayer is worth £100 with tax relief, while basic rate taxpayers have to pay £80 for the same result. 

If your employer contributes in line with your own contributions, it is even more imperative to invest in a pension. If your employer matched your contribution, then £60 from you net as a higher-rate taxpayer or £80 net as a basic rate taxpayer would be worth £200 in your pension pot. You will not get those sort of immediate returns in the stock market. 

Another benefit of pension contributions is that they reduce your taxable income, so it could take you below the £50,000 child benefit limit or the £100,000 personal allowance limit. These could deliver significant additional financial benefits.

Even if you or your partner are not working, each individual can contribute up to £3,600 a year to a pension and get 20 per cent tax relief – so a £3,600 investment only costs you £2,880. As everyone has their own personal allowance, it makes far more sense to have both partners in a couple generating some income in retirement rather than relying on just one income.

Lifetime limit

Although the lifetime limit is less than it used to be, the £1,030,000 limit still requires considerable commitment to get there. In order to reach the current limit at age 68, you would have to invest £5,220 a year if you start at age 20, £9,110 a year if you start at 30 and £16,800 pa if you start at 40 – assuming you invest at the start of the year and obtain an annual return of 5 per cent excluding costs. 

However, these are the gross amounts rather than the net, so while they may look unobtainable it could be easier than you think, in particular if your employer is also contributing alongside you. 

Some argue that the lifetime limit is an unfair penalty on successful investing, and it is true that if you are able to generate higher than average annual returns, you will reach the cap faster.

Key points

Pensions may seem an obvious choice for investors, over Isas, due to the tax relief.

Isas may help in tax planning if you might hit the lifetime allowance.

With Isas you will always have access to the money. 

If you are likely to reach the lifetime limit then you may want to take financial advice to protect yourself, but it is also the time to look at how Isas might help in tax-efficient planning. True, Isas do not come with the same initial tax advantages as pensions, and they are considered part of your estate for IHT, but they are highly effective in managing your income in retirement and, unlike pensions, there are no constraints currently on how much you can accrue within your Isa account. 

Another benefit of Isas is that they are not based on earnings and anyone can fund an Isa. In terms of finding the funds to top up your Isa every year to the maximum £20,000 annual allowance, some people will have the luxury of having enough disposable income or savings to do this, but if not you could consider using existing holdings to build up your Isa pot.

This is done through a process known as ‘bed & Isa’, where you sell assets in one account and transfer the cash to your Isa, buying the same holdings back if you want to do so. Most investment providers offer the option to do this effectively, and while you can not avoid all commissions or stamp duty, if applicable, it is a well tried and tested route to wrapping existing investments to generate the long-term benefits of a tax-efficient Isa. 

Unlike pensions, one of the primary advantages of an Isa is you always have full access to your money. As well as allowing you to supplement your income in retirement, an Isa can be used to fund a gap in income, for example if you leave work early or move to part-time before you can access your pension. 

Isas are highly tax-efficient in that there is no capital gains to pay on any growth achieved. Dividends are taxed at source, but there is no further income tax to pay. However, the biggest benefit is arguably that any income or gains released from your Isa are non-declarable, so they do not impact any allowances or take you into a higher-rate tax band. This makes it hugely attractive when it comes to taking benefits, as you can structure your income effectively if you have a choice of taking some money from your Isa and some from your pension. 

IHT consideration

When it comes to choosing how and when to access income in retirement, there are two key considerations to bear in mind. The first is income tax and the second is IHT. Overall, your main aim is to try and minimise the tax you pay in the short and long-term over your retirement.

In the short term, it is primarily about income tax. Using up your annual personal allowance is sensible and this will mean drawing down some of your pension. On the other hand, if you are approaching either lower or higher-rate tax bands, it is likely to be more beneficial to supplement your income using your Isa to avoid paying additional tax. 

In the long-term, it is about IHT and the different treatment between pensions and Isas. If you die before the age of 75, your remaining pension assets are passed on without IHT, whereas any remaining funds in an Isa are considered to be part of your estate. As a result, the standard advice is that you should draw down funds from your Isa first, before tapping into your pension.

However, the situation is potentially much more complex as there is a wide range of other considerations you should take into account. These include: the size of your pension (and implications of the lifetime allowance); the size of your estate (and implications for IHT); your state of health (and therefore life expectancy); and whether you still receive additional taxable income from other sources.

The huge IHT benefits do make it more beneficial to use up your Isa first. However, do not let IHT considerations overrule everything else. Make sure you have enough to last you through your retirement first and then consider how much you might want to pass on to your beneficiaries.

Rebecca O'Keeffe is head of investment at Interactive Investor