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5 ways to reduce tax in retirement

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…

Tax can be reduced if not fully avoided.

1. 25% tax-free

Rejoice! You can receive 25% of your pension savings tax-free.

It’s a good deal – your money originally goes into your pension tax-free and a quarter can come out similarly unmolested.

But how can you best capitalise on the government’s largesse?

Spend it

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 pension withdrawal rate – A particularly handy option if the stock market is having a rough time when you first retire.

Buy missing National Insurance Contributions

This enables you to boost your State Pension income and make a government-backed, index-linked gain every year for a one-off payment. It looks like being an especially good move when the flat-rate pension comes in.

Create an emergency fund

See below.

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 wedge.

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 received on behalf of a close relative saves 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.

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.

Bear in mind that an ISA’s tax benefits can now be inherited by a spouse or civil partner.

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 ever 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.

Any income tax you pay on the £2,880 is neutralised by the 20% gain as it enters your new pension. You can then withdraw the cash and make a gain on the 25% tax free element.

If you can withdraw the cash and still stay within your personal tax allowance then the entire £720 boost will count as a tax-free gain. (Remember that withdrawing cash from a pension counts as earned income).

Note, you won’t gain the tax uplift after age 75 and pension recycling with your 25% tax-free cash is a HMRC no-no. It is widely thought that HMRC will ignore any recycling gains that are less than 1% of your lifetime allowance (£1.25 million this year and £1 million next) but there are no guarantees.

4. Avoiding tax when you die

Post April 6 2015, pension pots inherited from someone who dies before age 75 will not be taxed – regardless of whether they are taken as a lump sum or income. It also no longer matters whether the retiree had previously tapped into the pension.

Annuity income can also transfer to a spouse tax-free, if you die before age 75.

Payments from inherited pensions must begin within two years or the beneficiary will have to pay income tax. Tax will also be due if your total pension savings exceeded the lifetime allowance of £1.25 million (£1 million from April 2016).

If you die after age 75 then inherited pension pots taken as income are taxed at standard income tax rates.

Lump sums are taxed at 45%. After April 2016, lump sums will be taxed at income tax rates. That could push a beneficiary into the 45% tax bracket for one year if the lump sum is big enough.

A pension will not be taxed as long as the money remains invested.

Check out this table to see all the tax wrinkles at a glance.

If you make it to 75, it may make sense to accelerate your drawdown rate and squirrel any surplus income into an ISA, as an ISA’s tax-free benefits can now be inherited by a spouse or civil partner.

Also, check that your pension scheme allows your beneficiaries to inherit any remaining savings as income rather than as a lump sum and that your pension provider knows who your beneficiaries are.

Because the old 55% death charge has been abolished, some people are now paying more into their pensions in order to help their beneficiaries avoid inheritance tax.

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 so that the minimum amount of household income is exposed to tax.

There is no special formula for this. 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.

Any more?

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 them in the comments.

Take it steady,

The Accumulator

Note: This article on avoiding tax in retirement was updated in April 2015. Archived reader comments below may refer to an older version or to outdated regulations, so check their date.

  1. Deferral rates looks set to fall when the new flat rate pension arrives in 2017. []
  2. An especially worthwhile trade in later years as mental faculties could well decline. []

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{ 74 comments… add one }
  • 51 Bellabeck April 14, 2015, 1:12 pm

    For IHT planning you can gift the ISA allowance to any adult children each year and invest in a stocks & shares ISA, accepting that it takes 7 years to fall completely outside of your estate. I share the decision making with my sons as a means of providing financial education, they are not permitted to spend this money!
    Also open a stakeholder pension or SIPP in your child’s name(s), pay £2,880 each year whilst dependent children/students i.e. until they start working and contributing to their own pension. We started stakeholder pensions for our two sons in 2003 and these are worth almost £75K each now.

  • 52 mickeypops April 14, 2015, 1:35 pm

    One other way to mitigate tax could be to use the Capital Gains allowance of up to £11,100 p.a. – for example if you’re paying higher rate tax from other sources then dividend income is going to attract an income tax liability over and above the notional tax credit.

    In these circumstances it may be better to switch from dividend paying funds to growth funds, for example, where a portion could be sold each year within the CGT allowance.

    I’m not an expert in this field. Perhaps the wise Accumulator could advise?

  • 53 The Investor April 14, 2015, 3:00 pm

    @mickeypops — I’m not sure CGT allowances are 100% on-topic, as they’re more of a general tax avoidance strategy that a specific retirement one, but anyway these articles may be of interest:

    http://monevator.com/defuse-capital-gains-on-shares/
    http://monevator.com/how-to-offset-capital-gains-with-losses-to-reduce-your-tax-bill/
    http://monevator.com/deferring-capital-gains-to-reduce-your-final-tax-bill/

  • 54 Fremantle April 14, 2015, 3:22 pm

    Timely update, your site gets more interesting with every reading.

    For self-employed limited company contractors who would otherwise be in the 40% bracket there are a number of other twists, such as paying yourself a small salary, contributing up to 80% of it to a SIPP, taking tax free dividends and paying yourself a company pension. You’d receive higher rate tax relief on your personal pension contribution and company tax deduction on any company pension contribution, whilst only paying employee NIC since you’re under the employer NIC threshold. It gets quite complicated if you’ve got other sources of income or you run a two person company and you would want to be careful paying your spouse a company pension.

  • 55 R Lee April 14, 2015, 3:30 pm

    So: I keep reading I should have some money in bonds, and that I should have bonds in an ISA because of the interest being paid gross

    1. Should I have money in bonds and why? If I can put money in the BS at 1.5% or buy a gilt paying 1.5% but which might lose capital value, why buy the gilt?

    2. What are the options for buying a cheap bond or gilt fund or etf which will pay dividends gross (not require a reclaim from the revenue)? I have looked quite hard for an answer to 2 and not come up with anything.

  • 56 Phil April 14, 2015, 3:37 pm

    R.Lee…you can buy corporate bonds on ORB, which is part of the Stock Exchange via Brokers (HL, etc). I have never bought, but that was where you could have picked up Tesco’s Bonds for 5.5% (i think). New IPO’s happen from time to time and you can sign up for email alerts. There have been some recent sales of new corporate bonds at around 5% for 5 years and they are able to be put in ISA’s (I believe).

    It seems a good way of establishing a tax free income stream.

  • 57 dearieme April 14, 2015, 9:52 pm

    “Also bear in mind that bonds are taxed as interest not dividends. They should definitely be tucked up in your Stocks and Shares ISA.” Does anyone know whether bond income is treated as interest for the purposes of the new £5k zero-rate income tax band for those with low incomes? And indeed for the £1000 p.a. allowance next tax year?

  • 58 dawn April 15, 2015, 11:06 am

    I only have a small private pension, so if it pays me £2,500 a year together with state pension id be under the tax threshhold so id be paying no tax on my pension . the rest of my money i could draw from my larger isa investments and cash which is tax free . so thats my way of thinking to avoid tax in retirement.

  • 59 Lesley mackin April 15, 2015, 9:52 pm

    There was an excellent article in ‘this is money’ recently suggesting you would be better off in some circumstances not taking the 25% tax free. Based on investing pension pot and taking out a set amount each year, living 20 years post taking the pension and getting returns each year of 4% . So lots of circumstances have to come together but article worth a read.

  • 60 Steve April 16, 2015, 1:18 pm

    “Does anyone know whether bond income is treated as interest for the purposes of the new £5k zero-rate income tax band for those with low incomes? And indeed for the £1000 p.a. allowance next tax year?”

    Yes, bond income is classed as savings so will be included in the £5000 allowance.

    It’s worth noting that pension income is classed as earnings for tax. So if you were living off savings income of £10k a year tax free, then start drawing a pension of £10000/take your pension as a lump sum under the new rules/start taking state pension then it will push some or all of your savings income into the taxable band.

  • 61 dawn April 16, 2015, 2:52 pm

    @steve
    theres no tax to pay if your income comes out of your isa no matter what income your on as its tax free
    yes pension income is taxable up to your allowance and once state pension [hopefully] kicks in at what will be around £7,500[curently] then that tax free allowance shrinks . so if your pension pays above £3,000 ish a year then there will be tax to pay on any pension payments above that.
    correct if im wrong someone.

  • 62 Steve April 16, 2015, 4:06 pm

    @dawn
    Sorry I was ignoring wrappers for the savings income, more trying to make the point that pension income is not classed as savings income, whether it’s an annuity or taking it as a lump sum (other than the 25% tax free cash).
    You’re correct about the pensions, state pension is taxable but paid gross so it eats into your personal allowance.

  • 63 Topman April 17, 2015, 11:48 am

    @Steve

    Hi. Probably worth just making the minor point that the normal state pension is always less than the personal allowance, so that those wholly dependent on the state pension are kept out of the tax system completely, as they definitely should be in my view.

  • 64 2l2r April 22, 2015, 4:29 pm

    Need to get some feedback from UK residents. I currently live in the US and part of our early retirement plan is to keep our joint income below 90K and as such pay no Federal tax ( see Curry Cracker) if said income is from LTCG’s/Qualified Divs. I lived for some years in the UK and still own a house there so moving back may also be an option for us. So I decided to see what can be achieved using a similar approach to the one above in the UK. I was surprised by the numbers – as there is no concept of married filing jointly in the UK we would apply half our investment income to each partner.

    Each person would be entitled to Personal allowance of 11k + 11K allowance for CG’s. Dividends payed by UK companies have a notional tax credit of 10% – which effectively means no tax up to 32K. So in theory I could have 52K in CG’s/Divs income and pay zero UK tax – that’s 104K per couple. Now this would mean limiting Div income to UK companies – but it’s still quite attractive. Am I missing something???
    Add the fact there is no State tax to worry about plus the benefit of lower property tax and healthcare costs ( relative to US) – the UK would seem and attractive option once the stash has been accumulated.

  • 65 Topman April 23, 2015, 11:26 am

    @2l2r

    Hi. You don’t give any nationality details. Whatever, if you haven’t already done so, it would be advisable to check out the situation for yourself and your spouse vis à vis UK “residence” and “domicile”, as defined for UK taxation purposes.

    I can recommend Tolley’s Tax Guide 2014-15 (Hardcover); available from Amazon at £83.78 (or somewhat less from other Amazon listed providers) it isn’t cheap but it’s used by finance professionals, and is comprehensive and reliably authoritative.

  • 66 2l2r April 23, 2015, 1:49 pm

    Thanks Topman – there are no residency issues as I have a Euro passport – unless UKIP have other plans ;). I lived for years in the UK and am now approaching retirement and exploring the option of living off investment income in the UK. My limited research shows the UK as somewhat generous in its treatment of passive income and I was wondering if I was missing something
    To summarize, a couple could in theory have up to 104K in income without paying any tax so long as said income was from CG’s (11k), dividends (32k) and other regular income (11k). Our passive income would not be close to that amount but just exploring the margins . Played around with this calculator to get my numbers – http://www.uktaxcalculators.co.uk/wizard/combined-tax-calculator-wizard.php

    thks

  • 67 Steve April 23, 2015, 2:25 pm

    @2l2r
    To reiterate Topman domicile and residence are big factors here. I’m not familiar with the euro passport and what that means. However if HMRC doesn’t consider you to be UK domiciled there can be heavy tax charges and loss of income and CGT allowances.

    Assuming domicile isn’t an issue it does sound ideal but it would be different in practice.
    – The £32k dividends you quote is after grossing it up by the 10% tax credit. In reality it is approximately £28.8k (still a lot!)
    – Lately there seems to be no consistency with dividends, with many companies slashing them.
    – I’ll be interested to know what investments you have that could realise £11k of capital gains year on year!
    – If you have UK residency could you start moving your investments into ISAs to reduce tax?

  • 68 2l2r April 24, 2015, 4:48 pm

    Thanks Steve – By Euro passport I meant European Union. Clearly all of the gains falling into place to maximize the yearly allowances would take some planning, however with the option for losses to be carried etc there would be some scope (maybe limited) to flatten CG’s across years and with a couple the possibility of moving funds and spreading gains across both sets of allowances.
    My plan ( not fully explored) may involve an Income fund – dividend focused alongside a growth fund where the 22k of income( per couple ) could be harvested in the years where returns warrant it and losses carried to future years again depending on return.
    Would certainly take advantage of any ISA option once resident – I’m guessing this vehicle would be good to harvest gains in excess of CG allowances ( in the good years).
    As regards domicile – I currently am not domiciled in the UK and yet still have access to the Personal Allowance and not been resident for more than 5 years am exempt from CG’s taxes.
    I have a question regarding the Dividends – does the allowance only apply to income generated by UK based companies, I understand that the income might be taxed by the country where the payer is based – but from a UK perspective does the Inland Revenue care on the source of the income.

    Thanks – great website

  • 69 Topman April 25, 2015, 12:12 pm

    @2l2r

    Rushing off to watch football but for a quick tip take a look at https://www.gov.uk/tax-foreign-income/taxed-twice

  • 70 Topman April 27, 2015, 4:25 pm

    @2l2r

    Bear in mind, re your EU passport, that there may be an EU in/out referendum in the next UK parliament.

  • 71 Jim Laird April 27, 2015, 11:45 pm

    Is it a fact that if a persons annual income falls below a certain figure his savings will not be taxed? If so what is the maximum figure?

  • 72 Eagsey May 5, 2015, 3:01 pm

    Is there away of preventing my Mum from paying HRT. She is aged 82 and gets annual income from my Dads death in service pension of £50000. This is paid to her monthly with tax deducted. On top of that she has state and other pension totalling £10000. So on a total income of £60k she is paying £13k tax of which £7k is hrt. I thought about her paying into a pension but you cant get releif over 75. Is there anything else she should be doing?

  • 73 Sam Dickson May 5, 2015, 4:43 pm

    Great tips, thanks. I am close to retiring myself (age 62) and can put these tips into use once my working career is over.

  • 74 Richard Smith June 28, 2015, 11:34 am

    I have always been a fan of making plans, and understanding exactly what type of taxation will apply to a certain type of investment, once you know then you know.

    Using tax deferred investments like ‘investment bonds’ issued by insurance companies can make some sense if you find one with the right charging structure – often the charges outweigh any potential tax savings.

    Owning your own business is helpful, especially if makes a small loss, provided it’s legitimate it can be helpful.

    ISA’s really make sense and if invested for income are very helpful when rolled up over the years.

    CGT allowances mean you can have a reasonable lump sum invested and enjoy stripping out gains – tax free. Just make sure you do that when markets are peaking and not at the bottom (conversely when investing only invest on the dips – few IFA’s will help you with that.

    2l2r – the whole question of domicile and residency is probably not one that can be answered here – it’s a pretty complex area and is dependent on a number of factors, however as a non resident and not ordinarily resident person you do qualify for some good tax breaks. Suggest specialist guidance is required, and there are some good resources on the web.

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