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. 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.
Useful article. Retirement rules are unbelievably complex and I’m sure many people between the ages of 55 and 74 are going to struggle to navigate through all the important decisions.
My fear with locking the money away in a pension is trusting the government not to change the rules. Will they raid my pension pot to subsidise all those unfunded public sector pensions for hard-working teachers and nurses?
Here’s another tax saving idea. If you’re trying to plan ahead and currently working for a friendly employer then you could use ‘salary sacrifice’ to increase the size of your pension pot. The idea is you give up some salary in exchange for your employer paying the equivalent directly into your private pension – this is a tax free benefit.
This saves all the income tax (which I know you could get back via SIPP contributions anyway) and also the NI, which is 12% for a basic rate taxpayer, dropping to 2% for a higher rate taxpayer.
It also avoids the employer’s NI of 13.8%, which is where the big saving comes. Some employers will agree to share some or all of this saving by adding it to the amount they pay into your pension.
Another advantage is avoiding the child benefit charge (although again you can do this yourself anyway via a SIPP). Pitfalls are associated with the lower salary – things like finding it more difficult to get a mortgage and reducing life assurance and redundancy entitlements.
I second that vote for salary sacrifice. My employer was too tight to share the employer win, but getting a 42% uplift to what went into my pension AVCs made a big leg-up, so much so that I accepted driving it down into BRT range where the win falls to a paltry 32%, which is still not to be sneezed at at all.
Although it probably varies from employer to employer, this didn’t change my life assurance or redundancy terms (it does change your statutory redundancy entitlements I believe).
You can’t sal sac to below the national minimum wage but depending on the hours your work you may end up becoming no longer entitled to the six months non means tested contributions based JSA if you work part-time. I never tangled with that system though I was probably okay as a full-time employee. I believe you have to earn over the NI Class 1 LEL which is £109 pw. You can nut your tax bill if you have enough savings to live on or are frugal enough but you can’t ground your NI using salary sacrifice. It’s a great way to stop HMRC stealing your hard earned cash and if it’s available to you you owe it to yourself to check it out!
People hate the terminology of reducing their salary so some people who went with their gut missed out. There aren’t many ways to dodge NI on PAYE but that’s one of them and it’s all legit and above board. Your pension and retired self will thank you for the sacrifice 🙂
This article just goes to show quite how generous the retirement tax breaks still are
Its perfectly possible to retire young-ish and pay minimal tax
For a couple you can still build up a £2.5m retirement fund tax free plus any VCT or EIS you fancy on the side
The problem for most people is that they cant save enough due to the small difference between their income and expenses
May be just worth mentioning the IHT tax break on AIM listed shares after holding for 2 years. Also these can be held in an ISA from this Autumn.
It would be great if at 50 years old you could access all your pension savings as a lump sum and it will be your responsibility to generate an income for life whether that’s via a PLA, Shares, ETFs etc
Retirement planning is over complicated by the government. After all, its my money and i delayed gratification to build that pot of money over the last decade. Agree with BeatTheSeasons, private pensions could be partially confiscated to subsidise state employees. Happened in Argentina. I’m personally not contributing to Sipp anymore, only my employer. I’m in ISAs now – wish they would up the limit to £20k pa.
I’m personally not contributing to an ISA at the moment, favouring a SIPP for tax reasons, but that will change if I look like getting near my magic figure of £333k – which gives you an £83k tax free lump sum and a leftover pot of £250k to drawdown at up to 4%, nicely utilising your 10k personal income tax allowance.
The 83k can then be reinvested into ISAs and eventually drawn on when required.
For me that is the tipping point, optimum tax efficiency gaining 40% + on the way in and paying nothing on the way out.
Beyond that the restrictions favour a mix of ISAs and possibly BTL property.
@Jon
I think the government is being pretty generous in letting you defer income tax in a SIPP
They basically gave me and the Mrs several six figure sums that way
Its only right then they want to make sure you don’t spunk the whole fund up the wall in a decade or two and fall back to the state (aka future tax payers) when you are broke
To my mind the current pension system is way too generous to the wealthy who have the income and time to plan
It would make a lot more sense to get rid of all tax reliefs and just have lower rates of tax
“To my mind the current pension system is way too generous to the wealthy”: it’s much less so than it was – the lifetime and annual limits see to that.
“a 55% tax guillotine on the pension that you pass on to your dependents”: oi, Monevator, remarks like this mislead people. There are plenty who consequently don’t realise that when they die their spouse can continue to drawdown, or buy an annuity, without any such 55% charge.
Salary sacrifice recently became a little less generous. Previously a couple could balance up their pension pots by getting an employer to pay into their spouse’s SIPP instead of their own. This made it possible to minimise tax on the retirement income generated – until the government closed the ‘loophole’ in April this year.
As with the child benefit charge, a policy which penalises families where one parent earns a high income and the other works fewer hours and spends time raising their children.
@dearieme
There are no lifetime limits on ISA, VCTs, EIS etc.
Just personal pension funds
It’s funny how different people perceive things differently.
I avoided pensions entirely for the first ten years of my working life (from late-90s onwards). That even included the couple of years I could have had an employer’s matching contribution — which was an error on my part, but not too much damage done given what happened to the market shortly after!
Pensions seemed to me — and I think were — far too restrictive, so I exclusively used ISAs and direct investment. In 2003/4 I put a fair chunk (for me) into VCTs, even, instead of using pensions.
However pensions have been made significantly less onerous with the various changes over the past decade, so that when I did an 18 month stint of 9-5 starting 3-4 years ago, I took up the company pension (and matching contribution!) to the extent that it wiped out my 40% liability.
It was a SIPP, which was effectively unheard of for the likes of me in the 1990s. So no more worries about fees or crappy investments. I can get a big chunk of money out at 55 tax-free, which because of the 40% relief makes the ongoing investment incredibly cheap to buy. And yes that ongoing sum will be taxed when I do draw it (which I will almost certainly do without an annuity — I’m not bothered about the specifics because they will no doubt have been faffed with over the next 2-3 decades) but given that I also use ISAs to shelter the rest of my savings, I think my overall tax profile will be low.
For 40% tax payers, pensions are a great deal now, to the extent the tax relief probably wont last forever. I’m not blind to the potential restrictions/changes, but I think they deserve to be part of my mix and barring unexpected success (or code changes) I don’t think I’ll pay much tax at 40% ever again. I personally wouldn’t set my investment vehicles up based on what happened in Argentina. We’re a completely different case — I’d say rich and solvent, but then I also want to say please can we keep politics off these investment threads, except to the extent that they directly impact on the investments/vehicles. Otherwise we risk going the way of the Telegraph comments et al.
(Politics on posts that are about politics — clearly a different matter).
VCTs are awful investments in the main, made mediocre by the tax relief. ISAs don’t have a lifetime allowance in theory, but in practice you have your £11K-ish allowance a year, so unless you’re immortal that’s fairly capped. 😉
This post is a great resource covering a shed load of complex material in a straight forward way. Despite that I am still vacillating over the ISa v SIPP decision. At 61 do the scales come down clearly on one side of the argument?
@Investor
I would disagree with you about VCTs, EIS etc
They can be a risk limiting way to invest in smaller UK companies because of the many and varied tax advantages on offer
One VCT I had managed to lose half its capital at one stage, but I was still doing okay because I had recieved years of tax free dividends and a 40% income tax relief up front. Having someone else take first loss makes you pretty sanguine
There are quite a lot of crap VCTs out there but then again there are quite a lot of crap collective investment schemes out there of any stripe
The fund management charges on VCTs are too high though
@ The Investor
Re your ongoing campaign to keep “politics” out of these comments – maybe you should define what you mean by this so we have a few ground rules?
Sensible pension planning should IMO include considerations like how the government might change the rules. We’re not Argentina, as you rightly say, but keeping a balance of SIPP and ISA balances is probably still a good idea. Your pension balances are, after all, a potential capital control!
The pensions timebomb, higher rate tax relief on SIPP contributions, generous benefits for wealthy baby boomer pensioners…… these are all ‘political’ areas where it would pay to look ahead rather than ignoring reality and then acting surprised when benefits get taken away.
But I do admit that moaning about the child benefit charge was a bit off topic!
@Investor, Beat
Unusually I have to agree the Beater here
You can’t really separate politics from any discussion about business and investing
Politics at its most basic is about who gets state resources and who funds the state with money
The state can destroy huge businesses and fortunes with a single decree, not just in Russia either
@Accrington Mike
It depends on your specific circumstances but the advantages of a SIPP increase as you get older. For the simple reason that as you get closer to being able to take the benefits the value of the tax bung is higher (it’s integrated over fewer years), and you are less exposed to the work of politicians (sorry guys!) either stopping the 25% tax-free pension commencement lump sum, or axing the 40% tax relief. You’re also more likely to be paying 40% tax as you get older – the 40% tax relief is almost as close to a no-brainer as you can get.
F’rinstance that young whippersnapper TI 10 years ago got a 40% leg-up on his contribs to the SIPP. But he’s had to do without his money for the last 10 years, and probably at least another 15 years from now, so a boost of 40% over 25 years is only a gain of about 2% p.a. over where he’d have been before on that money without the tax bung.
Whereas for an old git like me getting the same lift on the money I put into my AVCs which say I access in 5 years tax-free that’s a boost of 8% p.a. The 3.5% inflation rate means the boost is only a paltry 4.5% real, but still, you just don’t say no to that!
@ermine
Thanks for the response. Great advice . SIPPs it is then.
@Neverland @BeatTheSeasons — I do see why you’d ask for that. However I am reluctant to lay down ground rules at this point as then I’ll have to police them, we’ll get an unpleasant taste in the air, I’ll be accused of taking sides, and so on. I’d hope we’re still a small enough community to avoid that. (I’m hoping to bring a forum online soon which will have a special knockabout section for us to get stuck into this stuff, by the way. 😉 ).
In my view, for every balanced voice there’s 10-20x the number of Internet commentators on most sites claiming Britain is bankrupt, the country is going to the dogs, we don’t manufacturer anything anymore, buy gold as the £ is going to be utterly devalued, and lots of other IMHO factually incorrect opinions stated as fact. Meanwhile life goes on, GDP comes back (I see even the double dip has been revised away), inflation doesn’t explode despite all the naysayers, the markets rise etc.
And of course none of these commentators are accountable for their opinions 12 months down the line. (Strangely how often they managed to sell gold just before the it dropped 30%+, bought shares in 2009 even though they thought the country was doomed, et cetera).
As far as I’m concerned, 98% of political comment on the Internet is, to paraphrase Yeats, “Sound and fury, signifying nothing”, and I wouldn’t even excuse some of my own rants on the subject from that categorisation. 😉
For pensions and a “how to” post like this, I’d say something like a sensible note that administration A has talked about doing X or Y or opposition B has signaled clearly that it may look again at tax break Z is fair enough. I’d also say suggest something fairly neutral like “The pension burden is liable to rise in the years to come, so take that into account when choosing between A and B” or similar is fair enough.
Of course I’ve (or less likely my co-blogger has) gone off-piste with some sort of polemic as an article, I naturally expect people to vent their views as they see fit.
Basically I want the comments to be practically useful, for everyone’s benefit. 🙂
@Neverland — On VCTs, I bought into six or seven in 2003/2004 when the tax breaks were far better, and I by no means bought the worst of the bunch. (I’ve owned Baronsmead, Foresight, etc, among others). As I said above the tax breaks turned them from bad to mediocre, but the main thing that saved their bacon for me was that the whole market crashed so they were helped on a relative basis.
They took longer to move in some cases (after the tax break — so they fell from say 100p to 70p, but that only cost 60p) so I was able to shift money allocated to them over time into superior investments once the dealing restriction window had closed. (Then only three years, now five IIRC).
AS you say the charges are too high, and they’re also terrible at building book value, which virtually none of them have done. Contrary to what 90% of articles about them still insist in saying, they are not akin to true venture capital, and are nothing to do with high risk high return. Rather the best (say Northern) are moderate risk for a low but tax-attractive return as income.
If I was a pensioner with a lump sum to invest facing 40% tax on income generated, I’d possibly still consider them after exhausting other avenues such as defusing CGT etc, but I don’t see much attractions for anyone else, personally.
“the main thing that saved their bacon for me was that the whole market crashed so they were helped on a relative basis”: have you considered a career in PR?
@Investor
VCTs for building capital? :/
I see them more as income stocks where dividend growth (x fingers) will hopefully exceed inflation over a period
The VCTs I have tend to pay their capital gains away as dividends, even declaring special dividends if they do especially well
Divs for VCTs are a tax efficient way of recycling your investment without you having to sell shares at a discount to NAV
Remember also that a significant minority of the funds raised do not have to be invested in small companies so the “cash” part of the portfolio will act as a drag on capital growth, but keeps the dividends flowing
Probably the reason why your VCTs did so badly is that the funds you invested in 2003/04 actually put your money to work in 2005-07, which was the point when the stock-market and hence private companies were most overvalued
I hold Northern and Baronsmead among others and they seem to be delivering the 10-12% IRR I was expecting so far….
…the thing is half of that is coming in dividends each year
@dearieme — Hah! 🙂 Afraid my active trading side coming through there, I for one always think that way when juggling positions.
But VCTs have an in-built loss at the start (like most private equity) as initial fees immediately reduce the capital invested, and then the money is locked into investee companies and they pay any income to shareholders out of their own invested cash/ fixed interest (funny how many of them have done this — e.g. Ventus funds for a few years) which further reduces NAV, and then eventually the investments start to be written up in 3-5 years. No huge issue with that, it is how it should be (well, minus the early cash outs from investors own money) but as I say the return is pretty capped compared to normal PE / Venture Capital.
Anyway the point was I was roughly breakeven after the income tax rebate and those declines and the market had switched to being down roughly the same (2008) so I started swapping. So it worked, but really for the wrong reasons.
@Neverland — Well as I say above internet commentators always pick the winners… 😉
Congratulations, many did a lot worse.
Nowadays VCTs are promoted for income — and we both agree they have a role there, I just think it’s much more limited than you — but this was definitely not always the case. At the start they were touted as capital return vehicles. E.g. Literally the first thing I just Googled from a few years back (2008) is this Telegraph piece:
Further, I think besides the high TERs (which are typically 3% at least, and probably higher on a ‘hidden’ basis) eating away your return, the return of capital as dividends will likely prove deleterious over time for all but the best performers.
‘Proper’ Venture Capital (Sequoia etc) runs its winners to big gains to make up for the dogs. VCT venture capital keeps selling out of winners to pay out income, while hanging on to the losers.
There’s a reason why the VCT market is still so small, despite there being no shortage of rich people with cash to tuck away for tax avoidance purposes in the UK.
Each to their own of course, but to return to the purposes of this article they clearly have all kinds of potential problems, which I’d say are at least as problematic as the alternative of getting 40% tax relief on money put into a global tracker in a SIPP, where you get 25% of your sum invested back at 55 (and after that 40% relief) and the ongoing you can now manage in all kinds of flexible ways, compared to the old days. 🙂
The problem with using a Cash ISA for your emergency fund is that if you withdraw the money in an emergency, you can’t put it back in the same tax year. It makes more sense to use an instant access savings account with no withdrawal restrictions for the emergency fund, and accept that this will earn a lower rate of taxable interest, and to use the Cash ISA for long term savings, or as the cash part of an investment portfiolio, or to use the full Stocks and Shares ISA and skip the Cash ISA.
@ Dearieme – I rather thought I’d covered that off with the paragraph about the dependents pension being taxed as income. I can see it’s not as clear as I intended though so have updated.
@ Mike – glad you enjoyed the article. I second Ermine’s response. The closer I get to retirement the more I’ll be favouring SIPPs over ISAs. Anything over the 40% threshhold should definitely go into a SIPP, obviously anything that gets an employer’s match or is paid into an employer’s pension via salary sacrifice (so you don’t pay national insurance on it) and then it depends on how much 25% tax-free lump sum you want.
Diversifying between ISAs and pensions makes sense but doomsday pension confiscation predictions are overdone. No-one ever seems to mention that ISAs are vulnerable to political meddling too, but the reality is that the best way to defuse the pension timebomb is to make retirement saving more attractive for people not less. And by people, I mean the bulk of the country not the richest 5% who can probably get by even with curtailed lifetime allowances.
And when you get old enough, you see the advantage of an uncrystallised pension passing untaxed as a lump sum to your widow. (As alluded to, obscurely, in #3). And if you can take advantage of flexible drawdown, then you can effectively transform capital into income and give your excess income away free from Inheritance Tax.
Dear God the system needs simplifying.
And as more fully explained in #4. Pay attention!
@ The Accumulator(#25)
It doesn’t have to be an Argentine-style doomsday scenario. A future government might restrict the tax free lump sum, increase the minimum withdrawal age or means test the state pension according to the size of the recipient’s private pensions. None of these policies would be outrageously controversial with the general public.
This means anyone in their 20s, 30s or even 40s is taking a big risk if they lock too much of their money away in a SIPP. At least if politicians start meddling with ISAs you have the option to take your money out and put it somewhere else.
I agree with you that making pension savings attractive is the best way of resolving the pensions crisis, but that doesn’t mean it’s what the government will chose to do. There are lots of ‘best ways’ of solving problems which are too unpopular in the short term – building new power stations and airport runways springs to mind.
I would say that owning your own home(that you reside in) is a good tax avoidance strategy as you do not pay any tax on the imputed rental income. You also avoid any capital gains tax.
The other gain is you fix a chunk your expenditure. The alternative option is to invest more and so have a larger pot at retirement, but you are more vulnerable to increase in rental prices and poor investment performance. A downside is property is illiquid and expensive to sell, so moving into residential care or nearer to family is more expensive for an owner occupier than renter.
Over this kind of timescale there is always political risk. Morally it might not be right to tax labour heavily and land lightly, and economically it is likely taxes will discourage the supply of labour, but land is less elastic in supply.
@Beater
Really I have to disagree
Your options to me seem to be:
1) Pay the income tax up-front and pay income tax on the interest dividends at your prevailing marginal rate
2) Pay no income tax for funds invested in a SIPP and pay no income tax on interest/dividends until you start to take it out
When you are paying marginal income tax at 40/45% and you can take 25% of your SIPP out tax free its a no-brainer, especially if you in your 40-50s (If you are basic rate tax payer then the argument is more nuanced, for sure)
Note that the ability of past contributions made tax free to grow tax free for 20-30 years is what makes it attractive
None of the four most recent pension reforms has affected this ability
Each of them has followed the same formula, i.e. that you can stick with the limits of the previous regime provided you don’t make further pension fund contributions
I am pretty confident that the ability to get much up-front tax deferral at 40-45% will disappear in the next parliament either through up-front income tax relief limits, further trimming of the LTA or elimination of the 25% tax free lump sum withdrawel
This points to front-loading your contributions as much as possible before pension rules get worse, not restricting your contributions till later
Reading the HMRC link in detail, it looks like there is, in fact, scope to recycle some of the lump sum, as long as it doesn’t cause your pension contributions to increase by 30% or more over a 5 year period. Obviously this is a risky minefield and you’d probably want to take specialist advice. But I’d say there’s a loophole that allows you to recycle most or all of your lump sum directly back into your pension, claiming tax relief in the process, as long as you jack up your contributions 2 tax years in advance.
E.g. if you have £400,000 in your pension pot, you earn £60,000 and you’re 53 years old. You’re looking forward to a £100,000 lump sum but only need half of it to pay off your mortgage. Up your contributions to £40,000 and live off the other £20,000 or your partner’s salary for 2 years. You hit 55 and take the lump sum. Recycle £51,960 back into your pension and you haven’t made a “significant increase” to your contributions, as they’ve only increased by 29.99% over the “set period of time” set out here (which is an HMRC link contained in the notice that you’ve linked to in your article):
http://www.hmrc.gov.uk/manuals/rpsmmanual/RPSM04104950.htm
I think this works because HMRC have set out a series of 6 conditions which all have to be met to incur the tax charge, and in this example you are demonstrably not meeting 1 of them.
Discuss 🙂
@Ermine,
I don’t understand your logic re 40% tax relief on pension contributions or AVCs being more valuable later in life. Merely dividing the tax relief by the number of years doesn’t convince me.
If I put in £1000 and it costs me £600 and I leave it for 20 years, surely the £400 plus compound growth over that period is more valuable than £400 plus compound growth over 5 years nearer retirement?
@BeatTheSeasons,
I’m over 60, drawing occupational pensions and, yes, in theory, I could move money from ILSCs or ISAs into a pension plan and get a “tax credit” from the government.
Could that pension plan take any form such as a SIPP? Do stakeholder pensions still exist?
“you can pop £2,880 into a pension and get an automatic £720 bunk-up from the Government to take you to £3,600.”
Yes I could but I’d really need to do some hard thinking to see if it makes sense. I guess I might build up a pot of say £50,000 over 10 or so years having contributed £28,800. Yes the government will have given me £7200 in tax relief on top which will have grown tax free. Yes, I can then withdraw 25% of the £50,000 tax free leaving the princely sum of £37,500 to either buy an annuity or possibly use for draw-down.
Any growth of the £7200 will have been exempt of tax. But any additional income I draw in my dotage via an annuity or draw-down will be taxed. In hand, I’ll have £28800-£12500 (=£15,500) less cash than if I had not contributed to the pension but that ignores the growth of perhaps £5000-£7000 that I might hope to have had if the contributions had remained in ISAs: so perhaps £22000 less funds in ISAs from which I could generate perhaps 3% in tax free income without touching the capital.
Any of these rules could change over the next 10-15 years and you can bet they won’t become more generous. I shouldn’t be surprised to see the 25% tax-free lump sum disappear or be capped, as an example. I’d be astonished if relatively wealthy pensioners not only receive fewer universal benefits but also expect NI and income tax to be merged as an obvious rationalisation. The threshold for the 40% rate currently £41,450 (including the personal allowance) seems to be falling and more pensioners will undoubtedly fall foul of it.
My gut instinct is to forget about the potential tax relief and leave my funds in ILSCs and ISAs, possibly topping the latter up when the former are no longer eligible to be re-invested (bound to happen eventually or even before. That way I still have the tax relief on the investments, retain access to the capital and tax relief on dividend interest from the ISAs.
Any thoughts?
@BeatTheSeasons. I think you have misinterpreted the “significant increase” test. It is specifically designed to stop someone from increasing their pension contributions prior to getting the lump sum. The test looks at the cumulative increase in your pension contributions in the two tax years before, the year itself, and the two after. If they are increased by more than 30% of what would “normally” be your contributions then you fail the test. If you could should you “normally” increase your contributions with age or inflation etc then you could argue this as the base case.
IMO the best shot is to argue the pre-planned condition. The onus is on HMRC to show that you pre-planned i.e. consciously took the lump sum with the intention to use it to make a pension contribution. For example letters to your accountant, pension administrator …. unfortunately posting about the possibility on Monevator has probably also done the trick…!
@The Investor
> to paraphrase Yeats, “Sound and fury, signifying nothing”
It is Shakespeare, not Yeats 🙂
Gah! Of course it is, what a muppet. 🙂
“Any thoughts?” Herewith.
“I shouldn’t be surprised to see the 25% tax-free lump sum disappear or be capped”: ‘capped’ most likely, I’d think.
“I’d be astonished if relatively wealthy pensioners …”: defined by income rather than capital, I presume?
“… not only receive fewer universal benefits”: bound to happen.
“but also expect NI and income tax to be merged as an obvious rationalisation”: ‘fraid so.
“The threshold for the 40% rate currently £41,450 (including the personal allowance) seems to be falling and more pensioners will undoubtedly fall foul of it.” Good old ‘fiscal drag’ at work; the threshold might rise but it’ll fall in real terms.
“ILSCs and ISAs, possibly topping the latter up when the former are no longer eligible to be re-invested (bound to happen eventually or even before)”. Aye; we roll over three year certificates into five year for just that reason.
You’re assuming that ISAs will continue indefinitely; maybe, but if so I’d expect your total ISA balance to be capped.
Time to find out how to hold money/gold in Switzerland?
@ helfordpirate
Yes, I realised that. I was just pointing out that you could get round the rules entirely by increasing the level of your contributions 2 years early (or more specifically before 5th April + 2 tax years + period before you take the lump sump).
I think your approach is more dangerous because you are relying on not leaving any evidence that a scheme was pre-planned when it really was pre-planned. I guess if they wanted to prove it they could seize your computer and check the browsing history!
@BeatTheSeasons Your example specifically said “you” are 53, up your contributions for two years, take lump sum at 55. My point is that those two years do not set the base line for a normal pension contribution, quite the contrary they are considered as part of the recycling. What matters is what was your normal pension contribution in the period leading up to two years before you take the lump sum and what is a reasonable expectation of how you would have contributed in the absence of the lump sum during the 5 year test period. IMO
@GOP It’s the line I took and it worked well for me 🙂
TI puts £100 into his SIPP and it scales by 50% in real terms over 25 years to £200 in real terms. He’s had his money frozen for 25 years, but it only cost him £60. Let’s assume he takes it out as his tax-free PCLS, he has £200 for his round the world cruise.
Say he eats the tax hit and saves £60 in his ISA over 25 years, it becomes £120 in real terms after 25 years, same assets, different wrapper. He’s a year from retirement, still paying 40% tax and lives off his ISA, so he can live without £120 nett income which becomes 60% of what goes into a SIPP. The government would have stolen £80 from him in tax, but they don’t. In a year he gets to hoick £200 worth of real value when he retires.
To me the second scenario is more attractive than the first in the case of someone like TI who is competent with money, becaue he has more control.
There are issues with annual contribution allowances, with the temptation to spend it all on sweets and crisps and dancing girls and all the other reasons why pensions are age-restricted. But SIPPs are more valuable as you get older because there is less political risk, you’re more likely to be paying HRT when you’re older and the like. F’rinstance I never paid HRT when I was TI’s age then. I’d have been able to save £68 in my ISA (£100 less 20% BRT and 12%NI) giving me £136 at the end. Then as an old git I’d stick £136 of my income into a SIPP, run down that ISA, and end up with £226. I get a better cruise than TI.
I wasn’t as wise as TI would have been, so I ended up in the last three years of my career eating bread and water and foregoing holidays to save up a quarter of my pension pot to get the 25% PCLS saved up front and filling up my ISAs at the same time, I had already busted my mortgage, the absence of which helped me do that.
I do think pension saving becomes a lot more interesting as you get closer to drawing it. The important thing is to save strategically over your working life. There’s something to be said for taking the tax break later in life because you derisk the political scene and it’s likely to be more valuable (40% as oppopsed to 20 or 32% depending on if sal sac is available to you).
People who are in the 45% tax bracket probably have a harder time using this because of the annual contribution limits, so the usual adage that the time to open a SIPP is to cream off any of your income over the 40% tax threshold is wise.
Invest in dividend fund – couple can draw 80K+ year tax free
MOVING MONEY INTO ISA IN RETIREMENT.
Is this the most tax efficient way of moving money from the SIPP into ISA and then into living expense account when in retirement? Each year crystallise enough of the SIPP into 25% tax free sum to feed ISA contribution limit(£11800). Top up state and defined benefit pension from ISA dividend income or sale of stock.
Note my SIPP is closed to further input to preserve threshold.
The reasoning behind this is to reduce income tax as pension income is taxable but ISA income is not. This method may not be as tax efficient if IHT is involved as ISA is part of estate but SIPP is not. So should the ISA be run down and not deplete uncrystallised SIPP? Then, only when ISA is empty, start taking SIPP tax free , and then when all is crystallised start drawdown.
2/2r….
Are you able to elaborate on your statement that investing in a dividend fund can generate a tax free out payment of 80k tax free ?.
Are you UK tax resident ?
Thanks
Phil
Hi Mr Accumulator and Mr Investor
I’ve just read this old post via a link from Ermine, it’s so useful! Any chance of a new “Pensions” tab on the home page that will take us to all the old pension pieces in case I’ve missed some?
I’ve been educating myself through your site for the past year (understanding low fund and platform costs, being diversified, balanced, appropriate, not all eggs in one basket etc. and generally getting our savings and pension pots into sensible shape for two 60 year olds. Your posts (with the contributing comments) are helpful because they are referenced, then discussed rationally (no nutters or salespeople allowed!).
Thank you!
Oh! I’ve just seen Greybeard has a new post today, must read that…..
@Rowan Tree — Thanks for your comments, glad you’re enjoying our site. Archiving this stuff is a perennial headache, with pros and cons to all methods. However you could try using the Search box (top right).
Also, just for you: http://monevator.com/tag/pensions/
🙂
Hi! This post has now been updated to take into account the post April 6 2015 changes to pensions and ISAs.
Here’s some useful links if you want to know more:
https://www.pensionwise.gov.uk/pension-pot-options
https://www.pensionwise.gov.uk/tax
https://www.pensionwise.gov.uk/when-you-die
The Telegraph has published a tax avoidance scheme that takes pension recycling up a gear. I don’t like it, even the Telegraph admit that it could land you in trouble, but it’s here if you’re curious: http://www.telegraph.co.uk/finance/personalfinance/pensions/11528623/Pension-profit-use-new-rules-to-grab-instant-25pc-returns.html
Moving to a country where pension/foreign income isn’t taxed as heavily, and which have better climates and lower costs of living, has to be worth considering. Both Portugal and Cypress appeal.
How about getting a divorced and then remarrying so that your pension pot (and tax allowances) can be split with your spouse 🙂
Something that confuses me about the 25% tax free element:
If I have £100K in an untouched pension pot, and want to withdraw 15K today (using 15% of my allowance) what happens to the other 10% / £10K?
Would I still be able to get the other £10K / 10% tax free?
What if the day after I make the withdrawal my remaining portfolio doubles (I wish) in value to £170K. Would still be able to withdraw 10%, (£17K) or would it be locked £10K.
I’m not sure exactly what I’m trying to ask (!), but I guess its:
1) Is it locked down/set in stone at the point of first withdrawal?
2) If so is it locked as a remaining percentage, or as a sterling amount?
OK course, I’d have to learn how to spell Cyprus!
I have, fleetingly, thought about retiring to a tax friendly country. Belize, Cyprus, Malta and/or Bulgaria.
The concern is a tightening of tax residency rules as highlighted by Labour in their election pledges…i just don’t think it is as easy as they claim to escape the clutches of HMRC.
Health care is the other concern.
Does anyone know how long you would need to reside outside of the UK to ensure HMRC would not have a retrospective tax claim on your pension if for whatever reason you returned ?
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.
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?
@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/
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.
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.
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.
“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?
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.
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.
“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.
@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.
@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.
@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.
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.
@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.
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
@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?
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
@2l2r
Rushing off to watch football but for a quick tip take a look at https://www.gov.uk/tax-foreign-income/taxed-twice
@2l2r
Bear in mind, re your EU passport, that there may be an EU in/out referendum in the next UK parliament.
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?
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?
Great tips, thanks. I am close to retiring myself (age 62) and can put these tips into use once my working career is over.
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.
I was struggling a bit to understand stand the pension recycle part. In particular how this may apply if you need to pay any 40% tax in drawdown and also if you are surfing around the LTA limit.
Thanks