Interactive Investor

Six ways to keep your tax bill low in retirement

Every penny you hand over to HMRC, the less you’ll have to spend on doing things that you enjoy in later life. Craig Rickman shares six tips to help retirees keep the taxman at bay.

27th February 2024 11:58

Craig Rickman from interactive investor

No one wants to pay more tax than necessary, especially if you’re retired and your current pensions and investments need to last a lifetime.

And the combination of frozen tax thresholds and rising state pension means more of your income could be subjected to tax over the coming years.

So, with 5 April approaching fast, now is a good time to explore how to use your retirement portfolio effectively to either retain more of your wealth or support younger generations.

Here are six things to think about.

1) Get your ducks in the right row

If your retirement portfolio comprises a combination of self-invested personal pensions (SIPPs) and individual savings accounts (ISAs), the order you choose to draw from the two tax wrappers can be important.

In short, draining your ISAs first can be a tax-savvy approach. There are two reasons for this. First, income from pensions is taxable whereas with ISAs it’s tax free. This means you get to keep more of the income you receive.

Second, pensions, unlike ISAs, are generally considered outside your estate, so upon death any money in your SIPP can pass to your heirs free from inheritance tax (IHT).

If you die before age 75, they can inherit the lot without paying a penny in tax, whereas if it happens after this point, they will pay income tax on any withdrawals at their marginal rate.

However, be careful not to empty your ISAs. You never know what life might throw up, so it’s crucial to keep some accessible money that you can dip into should the need arise.

If you hold shares outside tax wrappers, consider using your annual capital gains tax (CGT) exemption where you can. This allows you to realise a certain profit every year without paying CGT. The allowance is currently £6,000 but will fall to £3,000 from 6 April, so it’s worth using before the end of the tax year if you can.

2) Use any remaining tax-free cash wisely

Most defined contribution (DC) pensions allow you to draw 25% of the fund tax-free from age 55 (rising to 57 in 2028), and this is clearly worth maximising.

But you don’t have to take the lot in one go; staging withdrawals can often be a prudent strategy.

If you’re worried that further SIPP withdrawals between now and 5 April will increase your tax bill, especially if you’re close to the 40% threshold, then consider any unused tax-free cash element.

You can either take 25% in one hit and move the rest to drawdown or do something called uncrystallised funds pension lump sum (UFPLS), which is where 25% of what you draw is tax free, while the remaining 75% is taxable.

If you choose the latter, it can be worth doing some calculations to make sure you stay within the 20% tax band.

3) Time your SIPP withdrawals effectively

When it comes to taking income from your SIPP, you should only ever take out what you need.

That’s because pensions grow free from CGT and income tax and, as noted above, are typically IHT exempt. Anything you draw from your SIPP that isn’t spent will form part of your estate on death and could be taxed at 40%. And unless you shovel the money into an ISA, any future gains or interest will be taxable, too.

But let's assume you need £20,000 in three months’ time to fund a specific financial goal such as a new car or to replace your kitchen; you’ve used up your pension tax-free cash and your accessible savings are either a bit light or earmarked for something else.

The timing of your SIPP withdrawals could determine how much tax you ultimately pay.

For instance, your annual income is £35,000 made up of the state pension, a defined benefit (DB) pension and income drawdown. This is the minimum amount you need to live comfortably.

As the 40% tax band kicks in once income exceeds £50,270, if you were to withdraw £25,000 after the 6 April, the amount of tax you pay would be 20% on £15,271 (£3,054.20) and 40% on £9,729 (£3,819.60) = £6,873.80, leaving you with £18,126.20.

However, if you took £12,500 before 5 April and £12,500 afterwards, you would pay 20% on each withdrawal (totalling £5,000), leaving you with £20,000 – a £1,873.60 saving.

This is a simplified example but underlines the importance of timing withdrawals effectively.

4) Be mindful of higher savings interest

If you’re someone who manages SIPP withdrawals to keep your total income below the 40% tax band, you should keep on eye on savings interest.

How much you can earn on your savings has jumped sharply in response to higher interest rates. While this has been a positive development, it also means you could face a bigger tax bill on any cash you hold outside pensions and ISAs.

Any savings interest above your £1,000 personal savings allowance - the interest a basic-rate taxpayer can earn every year tax free - is added to your total income and taxed accordingly.

The drawbacks of tripping into the higher tax band here are twofold: first you may pay 40% tax on your savings, and second, your savings allowance could drop from £1,000 to £500, adding an extra £200 to your tax bill.

If you still have some of this year’s £20,000 ISA allowance spare, it’s strongly worth considering before 5 April as anything you earn or make won’t add to your tax bill.

5) Gifting might be better than growth

While topping up your own pensions and ISAs can still make plenty of sense when you’re retired, the decision should be weighed up against your broader financial needs.

For example, protecting your wealth from IHT might be a bigger priority, especially if your retirement portfolio is already adequate to see you through old age.

While pensions are exempt from IHT, unless you still have earned income, funding is restricted to £2,880 (grossed up to £3,600 with tax relief) a year, and your estate beneficiaries may pay income tax on any withdrawals if you die after age 75.

So, in the event you have any spare cash to put to use by 5 April, it may be more savvy to fill up younger family members’ tax wrappers rather than use your own.

Beefing up an adult child’s pension savings can bring several benefits. Not only will it give their retirement savings a shot in the arm, but your contribution will get 20% up-front tax relief in the form of 25% government top-up.

And if your child pays 40% or 45% tax, they can claim back an extra 20% or 25% via self-assessment. In addition, if you can afford the payment from surplus income, you’ll gain immediate relief from IHT.

Alternatively, if your children are already financially secure, you could skip a generation and support your grandchildren. This could involve investing £2,880 (boosted to £3,600 with tax relief) in a Junior SIPP or adding to their existing Junior ISA, provided they have some of their annual £9,000 allowance left.

6) Seek alternatives if outright gifting isn’t an option

Gifting money is one of the simplest ways to reduce the value of estate, but it’s not always an option, even if you have an IHT problem. There are few prizes for bequeathing wealth that you need to live on.

If this applies to you, there are a couple of options to consider.

The first of these is trusts. Some trusts allow you to give money away but retain the right to take a fixed, regular income, which can strike a nice balance between estate planning and retirement income.

As you no longer legally own assets you move into trust, provided you survive seven years it will move outside your estate for IHT purposes. And some arrangements, such as discounted gifts trusts, can offer an immediate reduction from IHT.

But a note of caution here, trusts can be complex, so you should seek the advice of a regulated financial planner to make sure you’re doing the right thing.

A further option is to invest in AIM shares, which can offer 100% relief from IHT if held for two years and the stocks are qualifying. You can even wrap AIM shares up in your ISA.

This approach isn’t for the faint-hearted, though. Companies listed on AIM can be volatile, so you must be willing to stomach heavy losses which, if things go badly, could reduce the IHT-swerving perks.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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Please remember, investment value can go up or down and you could get back less than you invest. If you’re in any doubt about the suitability of a stocks & shares ISA, you should seek independent financial advice. The tax treatment of this product depends on your individual circumstances and may change in future. If you are uncertain about the tax treatment of the product you should contact HMRC or seek independent tax advice.

Important information – SIPPs are aimed at people happy to make their own investment decisions. Investment value can go up or down and you could get back less than you invest. You can normally only access the money from age 55 (57 from 2028). We recommend seeking advice from a suitably qualified financial adviser before making any decisions. Pension and tax rules depend on your circumstances and may change in future.