Pssst! Want to know how to reduce tax in retirement? Want to avoid the taxman’s greasy paws legally? Alright, alright, keep it down. Let’s take this someplace quiet…
(Whaddya mean that’s this blog?)
Here are the main points of the tax avoidance in retirement plan:
1. The 25% tax-free lump sum
Rejoice! You can receive 25% of your pension savings as a tax-free lump sum. It’s a good deal – your money goes into your pension tax-free and the lump sum element comes out similarly unmolested.
But how can you best capitalise on the government’s largesse, if you haven’t got a large debt, mortgage, or round-the-world cruise to pay off?
Aaah, the hedonist’s choice. But this is not as extravagant as it sounds. Using your tax-free cash as income enables you to:
- Pay less income tax, because spending the tax-free cash enables you to draw a smaller income from other sources.
- Hold off buying an annuity in the hope that rates will rise.
- Defer your State Pension – Currently your pension swells by 10.4% for every year you leave it untouched.1 Deferring enables you to buy a smaller annuity, as the State Pension can take more of the strain when your tax-free cash runs out.
- Reduce your withdrawal rate – A particularly handy option if the stock market is having a rough time when you first retire.
Buy missing National Insurance Contributions
You’ll boost your State Pension income and make a government-backed, index-linked gain every year for a one-off payment. It looks like an especially good move when the flat-rate pension comes in.
Create an emergency fund
Buy a Purchased Life Annuity (PLA)
A PLA is a conventional annuity that is bought with assets from outside your pension pot, such as with savings or your tax-free lump sum.
A PLA is like a non-stick pan when it comes to income tax, as less of it clings on than with a conventional annuity. That’s because a proportion of your PLA income is treated as a return of capital and is therefore tax-free. Only the interest part of the income stream is taxed.
The exact amount of tax you’ll pay every year is determined by mortality tables. The quote I’ve recently received on behalf of a close relative I’m helping out will save her 75% in tax, for no loss of income versus a conventional annuity of the same price.
2. Emergency funds and ISAs
Siphon your tax-free cash into an ISA and it will remain safe from the taxman. Interest, capital gains, dividends, income – it’s all off the tax radar. This makes an ISA the perfect place to shelter some of your wealth for a rainy day or stormy season.
This year’s annual ISA allowance is £5,760 for cash or £11,520 for stocks and shares. Alternatively you can split your £11,520 allowance 50:50 between cash and shares.
Arguments rage in the forum firmament over the most tax-efficient way to use ISAs. The theory goes that many basic or non-tax payers don’t benefit much from loading equities into their ISAs, because they have a generous capital gains tax allowance and because they aren’t taxed on dividends.
I’d always put equities into my ISA first. The average soul has no interest in capital gains management, and by using an ISA you’re likely to save yourself a lot of work and worry in exchange for a slightly bigger tax bill on your cash.2
Also bear in mind that bonds are taxed as interest not dividends. They should definitely be tucked up in your Stocks and Shares ISA.
Note ISAs lose their tax-free status on death and fall into your estate, so are potentially liable for inheritance tax.
Finally, let’s pipe up a lament for the dearly departed National Savings Certificates. These tax-free, government-backed savings vehicles were last available in lots of up to £15,000 per person in 2011. Grab ‘em if they come back.
3. Pension income recycling
Surplus income can be recycled into a new pension to scrub it clean of income tax. Even if you’re fully retired and not earning a bean, you can pop £2,880 into a pension and get an automatic £720 bunk-up from the Government to take you to £3,600.
The income tax you pay on the £2,880 as it leaves one pension is neutralised by the 20% gain as it re-enters your new pension. The accumulated assets in your new pension can eventually be crystallised as a new tax-free lump sum and can avoid certain death charges, if you die before age 75. More on this below.
Note, you won’t gain the tax uplift after age 75 and pension recycling with your 25% pension lump sum is a HMRC no-no.
4. Phased drawdown to avoid the death charge
Phased drawdown is designed to avoid a 55% tax guillotine on the pension that you pass on to your dependents.
- Normally, a pension in drawdown will suffer a 55% tax charge on any lump sum paid to dependents.
- In contrast a pension that hasn’t been touched pays out tax-free3 if you die before age 75.
The idea of phased drawdown is to limit the tax damage by dividing your pension into packets. Some packets are opened to provide your current income and they will take the 55% hit upon your demise.
The remaining packets are left unopened until needed. They sit untouched in your pension scheme and will avoid the tax charge if you die before 75.
This system also means your 25% tax-free lump sum arrives in stages as you open each new packet.
The upshot is your lump sum is depleted in the most tax-efficient way possible, bolstering your income for several years while reducing your exposure to income tax.
You can also buy a ladder of annuities via phased drawdown. With any luck you’ll benefit from better annuity rates as you age (and your life expectancy diminishes), although rates will also fluctuate based on the performance of underlying assets.
Phased drawdown requires an amenable pension scheme or pension assets that are divided between multiple schemes.
Bear in mind that if you die after age 75 then any lump sum paid to your dependents will be holed by the 55% death charge, come what may.
If you make it to 75, therefore, it may make sense to accelerate your drawdown rate and squirrel any surplus income into an ISA.
If your scheme allows for a dependent’s pension then this can be paid as income to your survivors who will pay their usual dose of income tax on it.
5. Personal allowances
Retirees used to benefit from a more generous personal allowance, but this has been axed for anyone born after April 5 1948. Now they get the same as the young ’uns.
The age-related allowance has been frozen for anyone born before the threshold, and it will gradually be worn away as the mainline personal allowance rises.
The State Pension is taxed as normal, too, so any income you earn over your personal allowance will be taxed at 20%, and then 40% – and 45% if you’re doing very well.
The trick for couples is to make sure that you both max out your personal allowance when you retire. From next year that equals a tax-free, joint income of £20,000 – which is enough for Mr and Mrs Accumulator to live on quite happily.
There is no special formula. Just keep your eye on your retirement forecast and make extra pension contributions where they’re most needed, buy missing NICs, consider deferring your State Pension, and so on.
That’s all the methods to reduce tax in retirement I know about. (At least without consulting high-fee specialists with offices in the Cayman Islands, Liechtenstein, and Bermuda…)
If anyone else knows any legal tax avoidance techniques then please post ‘em in the comments.
Take it steady,
- Deferral rates looks set to fall when the new flat rate pension arrives in 2017.
- An especially worthwhile trade in later years as mental faculties could well decline.
- Assuming it doesn’t exceed your lifetime allowance.