Planning your income for retirement

You’ve spent your working life building up your savings and investments across different pension, investment accounts and ISAs. When the time comes, it’s worth having an eye on the way different income sources are taxed.

By understanding how your tax-free allowances, you can make your wealth last longer through retirement and keep more of what you draw.

Personal allowances and tax bands

The main tax-free allowance for income is £12,570 a year for most people. It’s also possible for spouses and civil partners to transfer some of their own unused personal allowance to their partner, if they are still a basic rate taxpayer. This could save you up to £252 in tax for the current tax year.

Above the personal allowance, your income is taxed in bands at different rates.

• Basic rate band – up to £50,270
• Higher rate band – from £50,271 to £125,140
• Additional rate band – above £125,140

The order of taxation

Income can come in different forms, but there is a set order in which it is taxed.

NB: Scottish taxpayers have different rates and bands for income tax.

ISAs

Withdrawals from ISAs are completely tax-free. Whether it’s interest, dividends, or money you take out from selling investments, you can keep all of it and it doesn’t need to be declared on a tax return.

We all get a £20,000 annual allowance for ISAs each year, and there’s no upper limit for the value of your pot once contributions are made and you enjoy investment growth. This means it’s possible to have built up a decent ISA pot in your lifetime.

You can also continue to top up your ISAs in retirement (apart from Lifetime ISAs) to continue to boost your tax-free income, either from your pension tax free lump sum or by wrapping up your existing cash and investments.

Accessing your pensions 

You can usually take up to 25% of the value of your pension(s) tax-free (subject to the overall lump sum allowance of £268,275) with withdrawals above this level subject to income tax at your marginal rate.  

Most people still like to take their maximum lump sum when they come to access their pension. It’s one of the most valued and well understood tax breaks of pension saving. But you don’t have to take it all at once. It’s also unlikely to be the most tax efficient method of extracting your cash over time, unless you have big plans for the lump sum right away, or you’re looking to use the rest of your pot to buy an annuity to give you a secure, guaranteed income for life.

If you’ve still got your heart set on taking your full tax-free lump sum, you can leave the rest of your pot invested to give you an income, as and when you want it. This can be zero in the early years, or a taxable income up to higher rate tax band in later years, if your spending plans allow.

One alternative is to access chunks of your pension at a time, with 25% tax-free and the remaining 75% taxable. These are officially known as uncrystallised funds pension lump sums. They can allow you to plan tax-efficient withdrawals from your pension each year.

 With the government’s plans to bring pensions into estates for inheritance tax, some people are considering taking more income from their pensions to make regular gifts. Although the income is taxed in your hands, using it can help others to make extra pension contributions and that boosts their own retirement pots, and they’ll also get tax relief on the money paid in. In some cases, this could cancel out (or even be worth more than) the income tax you paid on the way out. 

Gifting and IHT rules can be complex though, so getting some professional advice could help to avoid any costly mistakes.  

It’s also worth keeping in mind that you’ll be able to claim the state pension at some point, which although paid gross, will also count towards your total income for tax purposes.

Get a state pension forecast to see how much you could get and when. You can choose to defer your state pension, and you’ll get around 5.8% for each complete year you don’t claim it for. While this can be tempting to save tax, you’d generally need to live for around another 20 years to see the financial benefits of deferring.

Non-ISA accounts

We’ve covered the tax rates for cash and investments outside of an ISA, but some investors have been turning to gilts (UK government bonds) as a cash alternative, particularly if they’ve maximised their ISA allowance and they want to boost their tax-free returns.

Gilts are now offering much higher yields, and though interest rates could move against them, they now look like a much better investment than they did five years ago. As direct UK government bonds aren’t subject to capital gains tax, some investors have loaded up on low coupon gilts as a tax-efficient cash alternative to top up their tax-free income.

Much of what I’ve described isn’t anything new – but the recent Budget has led some people to review their plans and perhaps spend a bit more from their own pensions in their lifetime.

Rather than exhausting one type of account before the other, a blended approach to support your retirement will help you make the most of the tax allowances, and perhaps mean you can help your loved ones too, if that’s also one of your goals.