Use Allowances to Minimise Taxes in Retirement3rd January 2016
Most people will have accumulated a range of assets and potential income sources when they reach retirement, including pensions, ISAs, bonds, investment funds and more. Each of these is treated differently from the tax perspective. Therefore, which ones to draw cash from and which ones to leave untouched and keep growing can have vast implications on the taxes payable – both in retirement and after you die.
Combine Multiple Income Sources to Minimise Taxes
There are various tax exemptions and allowances on different kinds of income. They enable most individuals to receive at least £26,700 entirely tax free (which will increase to more than £33,000 in 2016/17) – and double these amounts for couples. The key to minimising taxes, fully enjoying the fruit of your hard work and preserving your legacy is to use these allowances to the maximum. In other words, draw income from the right mix of sources. Receiving all your income from a single source (for example from your pension only) is rarely the most tax efficient strategy.
The following are the most significant allowances. They apply to most taxpayers, although depending on your particular situation some of them might not be accessible to you (for instance if your total income is very high). Conversely, you may also be entitled to other tax exemptions or allowances not listed here (for example if you have a disability).
|What you can get tax free||2015-16||2016-17|
|Savings Interest Allowance||£5,000||£5,000|
|Personal Savings Allowance||–||£1,000|
|Capital Gains Tax Allowance||£11,100||est. £11,100|
1) Personal Allowance
Currently at £10,600, the basic Personal Allowance will be increased to £11,000 in 2016/17. It can be used for a wide range of income sources, including particularly earned income such as salary or pension. It applies to vast majority of taxpayers, with the most notable exception being those with total income above £100,000 where the allowance is progressively withdrawn at the rate of £1 for every £2 you earn above £100,000.
2) Interest Allowances
Interest on savings accounts or bonds (including offshore bonds) is tax free up to £5,000 if your earned income (e.g. pension) is below the Personal Allowance (£10,600 as above). If your earned income is higher, the Interest Allowance is withdrawn at £1 for every £1 of earned income above the Personal Allowance. For example, if your earned income is £12,000 (£1,400 above the Personal Allowance), you can only receive £3,600 in interest tax free (£5,000 less £1,400).
From April 2016 there will be another Personal Savings Allowance of £1,000 (for basic rate taxpayers) or £500 (for higher rate taxpayers) on top of the above.
3) Capital Gains Tax Allowance
This one, known as the Annual Exempt Amount or Annual Exemption, allows you to take a certain amount of capital gains tax free. It is £11,100 in 2015/16 and rises with inflation (rounded to £100) every year.
You normally have to pay capital gains tax when selling your investments, such as stocks or mutual funds (unless they are held within a wrapper such as an ISA). It is worth noting that capital gains tax is only payable on the profits (the positive difference between selling price and purchase price), but when selling investments you also get the original capital back, which is not subject to tax. Therefore, you may be able to get high amounts of cash and pay zero taxes.
4) Dividend Allowance
From April 2016 the tax treatment of dividends will change and there will be a new Dividend Allowance of £5,000. It will not reduce your total income for tax purposes, but the first £5,000 of dividends will be tax free, regardless of your non-dividend income.
New Pension Freedoms and Inheritance
There are other factors you need to consider besides taxes payable on your retirement income every year. Above all, it is inheritance tax and passing assets to your children.
The new pension freedoms and death benefit changes have turned retirement income and estate planning strategies upside down. Before the reform, traditional advice would have been to use and spend your pension first. Under the new rules, you may want to leave your pension alone or limit your pension income to the Personal Allowance only and use your other investments to fund your life in retirement. The reason is that the reform has made it much easier and more tax-efficient to pass your pension to your spouse, children or other beneficiaries after death, potentially saving a lot of money on inheritance tax.
You Don’t Need to Spend It
If you have a range of assets available, you should always use the right combination of income sources in order to fully use all the allowances. Keep in mind that they always apply to the particular tax year only – if you don’t use them by 5 April, they are gone. Therefore it is wise to draw the income and use the allowances even if you don’t need the cash at the moment. Instead of spending, you can reinvest it in a way that will reduce your future taxes – for example in an ISA (which is entirely tax free for good) or some other investment (with higher base cost).
The amounts and conditions change every year and it may be hard to keep track of all the available allowances. That said, the potential tax savings can be enormous. A good adviser will help you understand and take advantage of them.