Opening retirement income options

Phil Carroll runs through a worked example detailing how you can efficiently supplement a client’s retirement ‘income’ through other tax wrappers.

Much has been written around the recent pension funding changes and reduced lifetime allowance. For many this may not cause a problem. However, the lack of access before age 55 and low annuity rates has meant that clients may wish to consider other investment wrappers alongside pension wrappers to achieve retirement goals.

Using capital as ‘income’ can be extremely tax efficient. Consider John, (42) who has a pension pot worth £175k and an ISA worth £30k and wants to retire at 63. Both are tax efficient investments from an income and capital gains perspective but one receives relief on the way in and is taxed on the way out (except for tax-free cash (TFC) of 25%) whereas the other receives no relief but offers instant access and no restriction on how the asset can be used.

Combining both can create an excellent ‘income stream’, minimise tax and meet the shortfall created by the delayed payment of state pension. Clients may wish to retire or semi-retire earlier and meeting this gap will be crucial. Planning with the state benefits to kick in at a certain age can help formulate the outline of a tax efficient income plan. Assuming 2.5% indexation for allowances and inflation and a 6% growth rate after charges the following assumptions could be made. On the assumption that state pension age will be 67, when John reaches that age, the proposed £140pw minimum pension, would equate £260pw and the £20,000 minimum secured income requirement (to allow flexible income in retirement) would be £37,000. We are not yet at the Government’s target level of £10,000 personal allowance but assuming we get there in the next few years this would be valued at £18,500 for John at that age.

The respective investment pots would be worth £595k and £102k. Tax-free cash of £148,750 could be taken but consideration is needed on where this is going to be invested and how any income then received would be taxed.

Annuity rates at 63 (John’s preferred retirement age) are today approximately 6.0% compared to 6.84% at 67 and age 75, 8.9%. Clearly deferring annuity purchase (if at all) does offer benefits but this needs to be weighed against the years of lost income, but only if John needed it. Generally the pension pot is also IHT exempt which is an important consideration when looking at capital extraction to meet income requirements. However, if TFC is taken the remaining crystallised fund will suffer a charge at 55% if death occurs before age 75 and is distributed as a lump sum. The pension fund could be reduced on an annual basis to provide the required ‘income’ (TFC of 25% and a small annuity) to avoid exposing the uncrystallised remainder of the fund to the 55% charge. Finally, at age 67 the state pension will be equal to £13,500 per annum. Assuming John wanted an income of £25,000 per annum today, this would be equal to £42,000 at age 63.

Leaving the pension invested for, say, a further four years after taking TFC could enhance the value to £597k. Assuming no other assets and income at age 63, then establishing a drawdown of assets could achieve the desired outcome.

The capital value of the ISA and TFC clearly exceeds the required ‘income’ without any growth, but investing efficiently so that income produced from the capital along with capital withdrawals could result in virtually tax free ‘income. If the TFC was invested into an OEIC after utilising the client’s available ISA allowance for that year (which would be £18k based on previous assumptions) the following could be achieved:

 Investment  Income-  interest tax  treatment  Income -  dividends tax  treatment  Withdrawal of  capital tax  treatment
 ISA (Value £120k)   Tax free   Tax free   Tax free
  Collective (value £130k)  (£18,00reinvested from tax-free  cash intoISA)  Taxable but maybe  within personal  allowance  Taxable but maybe  within personal  allowance  Tax free up to  use of CGT  allowance

John could achieve his income requirements by drawing real income from the ISA tax free and then encashing units in the collective and ISA to meet the shortfall. Overlaying tax efficiency onto the underlying wrappers would potentially mean that you would maximise fixed interest returns from the ISA, and equity gains under the collective to the level of utilising CGT allowances. Efficient extraction of both income and capital growth could mean next to no tax would be paid by John, his income requirements would be met and his pension pot (after TFC) would remain invested for longer.

The need for pension shortfall planning between actual retirement and when the modified state pension kicks in is an excellent advice opportunity and area to demonstrate knowledge on how to use wrappers efficiently now and in the future. The tax tail should never wag the investment dog or be a barrier to clients’ objectives but using multiple wrappers can be a strategy which adds flexibility both pre and post retirement.

The information provided in this article is not intended to offer advice.

It is based on Old Mutual Wealth's interpretation of the relevant law and is correct at the date shown on the title page. While we believe this interpretation to be correct, we cannot guarantee it. Old Mutual Wealth cannot accept any responsibility for any action taken or refrained from being taken as a result of the information contained in this article.

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