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Retirement income: planning considerations

by
01 April 2015, at 12:00am

DYLAN JENKINS discusses the changes in the legislation on pensions which come into effect this month and the need to consider carefully the tax implications so you avoid an unwelcome bill

IN this article I am aiming to provide insight on how best to structure one’s investment portfolio given the new pension freedom legislation that takes effect from 6th April.

The new pension income flexibility and greater inheritability of pension wealth means that traditional thinking on retirement income planning has changed dramatically. However, from 6th April, it is still likely to be better to retain pension savings within the pension wrappers and take income from other investments first.

Much of the talk about the pension changes post-Budget focused on the fact that unrestricted access to pension savings could be a temptation too far for some. But stripping out the fund in one go would mean an entire retirement’s worth of income tax liability would be taxed in a single tax year, which would probably result in a large and unwelcome income tax bill!

In addition, it would bring the value of the pension back into the estate for the purposes of inheritance tax. In April, the personal income tax allowance is set to increase to £10,500. In addition, it will be possible to take a further £5,000 savings income tax-free. Then, of course, there’s the annual capital gains tax (CGT) exemption which will stand at £11,100.

This means a total of £26,600 of income and capital gains each year can be taken tax-free by just making full use of the available exemptions.

If, however, retirement income is being provided from the pension alone then £16,100 worth of tax allowances could be missed. That’s because the savings band begins to be removed once earned income (which would include pension income) exceeds the personal allowance; and with regard to the annual CGT exemption, if you don’t use it in a year you cannot use it in the future.

It’s also important to look at what will be available to family members on death and that means paying attention to inheritance tax and, in particular, the new pension death benefit rules.

To make the most of these allowances it pays to have saved across a range of different investment tax wrappers after maximising your pension and ISA allowances.

Each tax wrapper has its own particular tax characteristics. Having a combination of these wrappers can provide flexible tax-efficient income and estate-planning solutions.

The ability to turn income on and off as required can open up much more 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 utilising allowances which, in turn, can lead to reduced rates of tax.

Of course, it won’t be possible to turn income on and off from all pensions – such as state pension or final salary pensions. This could mean flexibility is needed, such as using the years before these fixed retirement incomes commence as a window of opportunity to take income from other investments taxefficiently.

Unlike most other assets, pension funds are rarely subject to IHT and the new death benefit rules scrap the 55% tax charge on drawdown death benefits.

There will be more options for passing on pensions as well, as 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.

ISAs will work well alongside pensions, and are probably the simplest wrapper to understand. There is no income tax or CGT when income or funds are withdrawn. This, combined with the fact that funds grow free of tax, means they’re a popular investment choice.

However, on death, ISA funds will usually form part of the estate and where IHT is payable, this will leave only 60% of the fund inheritable.

Capital withdrawals from unit trusts and investment funds can also supplement income and provided gains don’t exceed the annual exemption (£11,100 in 2015/16) this will not be taxable. An investment fund portfolio will form part of the estate for IHT so withdrawing funds to meet income reduces the potential IHT bill to preserve pension funds.

Investment bonds can also be used with these other investments effectively and, whether onshore or offshore, they are unique in that income and gains are rolled up within the fund and only become taxable when a withdrawal triggers a chargeable gain.

In addition, withdrawals of up to 5% of the original capital can be taken without an immediate tax charge. This ability to defer and control when income becomes taxable is a very valuable tool for tax planning.

Timing withdrawals to coincide with tax years when there’s little or no pension income can result in gains falling within the personal allowance and savings rate band, meaning no tax is payable.

And with offshore bond gains taxed as savings income, a non-taxpayer could have gains of up to £15,500 which are completely tax-free, thanks to the changes to the savings rate band from April.

There is a lot to consider and I appreciate that this might all sound a little complex when first considering your options.

My advice would be to seek further insight and support from a qualified independent financial planner who will be able to help you outline your main objectives and put a financial plan together to help you reach them.