By Ben Klein, Senior Wealth Manager
At Tideway, we often talk about generating tax efficient income in retirement and indeed, much of our work is centred around providing this advice. However, what do we actually mean by this? This note aims to cover the basic points and provide practical steps that can be taken to reduce your tax and maximise your income.
Firstly, let’s consider the main tax allowances available to a UK resident client:
There are, of course, many more tax allowances available, but these are the main ones that should be utilised first before exploring other tax allowances. We have recently written about the benefits of offshore bonds and, while very tax efficient, they are generally used to provide further tax planning, once the above allowances have been used.
It is all well and good having these available allowances, but how can you benefit from them? There are a number of accounts that are available to ensure that they can be utilised, but we at Tideway believe the three to be prioritised are:
Now, the crucial part. It is imperative that the ‘correct’ investments are made in each account to ensure that a) the tax allowances are being used correctly and b) the overall risk of the portfolio is suitable.
To explain this, let’s review a case of a client we have recently advised. The numbers have been simplified slightly, but the strategy remains the same.
John is 59, married, he has recently retired and is a cautious investor. He transferred his defined benefit pension in late 2016 and after some fantastic growth, it is now worth £1.3m. He has Individual Protection of £1.12m, meaning he can take a maximum tax free lump sum of £280,000. He would like a net income of £40,000 p.a. He has some cash savings that have used most of the personal savings allowance.
He could simply take an income from his SIPP. He would have to withdraw a gross amount of £46,875, paying £6,875 in tax to provide the £40,000 net. This means a tax rate of 14.7%.
Alternatively, he could employ the following strategy:
Back to the crucial part: the underlying investments need to be correctly allocated to each account to ensure maximum tax efficiency and the overall risk remains appropriate.
The pension is invested in a cautious, multi-asset portfolio, our Stable Return Two portfolio. The pension is still a large account and needs a suitable level of diversification across different asset classes, region and styles etc.
The ISAs are invested in fixed income funds (bond funds), our Bond Income portfolio. The income of approximately £1,600 (from next tax year) generated by these investments each year will be tax free as they are held within the ISAs.
The GIAs are invested in equity funds, our Equity Blend portfolio. The yield on this portfolio is c2%, thus creating dividends of £2,000 each and no tax to pay. If fixed income funds were invested in this account, then income tax would potentially be paid on the income. Gains would be taken each tax year up to the capital gains tax allowance and future ISA contributions can be funded from this GIA.
Overall, the portfolio remains cautious by balancing the higher risk GIA with the cautious pension and ISAs.
As you can see from the diagram above, the net income of £40,000 is achieved by only paying £5,075 in tax; an effective tax rate of 11.3%, saving £1,800 of tax.
Although this example is using tax free cash from a pension, the same can be achieved with cash held in a bank account, for example. With taxes likely to rise and interest rates on cash (and cash ISAs) likely to remain low, ‘sweating’ the tax will become ever-more crucial in the coming years.
At Tideway, we have followed this strategy with success for many of our clients and so if you feel you may benefit from this or would like to discuss this further, then please contact your wealth manager.
The content of this article is for information purposes only and should and should not be construed as financial advice.
Please be aware that the value of investments, and the income you may receive from them, cannot be guaranteed and may fall as well as rise.
The information contained in this document related to tax are correct at the time of issue; however, tax legislation and the levels of relief are subject to change at any time.
We always recommend that you seek professional regulated financial advice before investing.