- Retirement income offers much greater flexibility nowadays, but there are also a few pitfalls to be wary of.
- Our tax situation can change when in retirement, with new decisions to be made and costly errors to steer clear of.
- Working with a financial adviser can reassure you that your plans are moving in the right direction and that you take your retirement income in the most tax-efficient way.
The tax pendulum
It was once the case that your journey as a pension investor effectively came to a close on reaching retirement. Thankfully, the 2015 reforms to Defined Contribution (DC) pensions put a stop to that, meaning that many individuals remained invested during retirement. These days, the process is much more seamless – and for some people, very little actually changes.
Yet certain things do change, and it pays to be mindful of them. One of the most obvious points is the way in which you’re taxed once you start taking an income in retirement. It goes without saying that there are increased opportunities for tax efficiency nowadays, but there’s also a greater risk of making a costly mistake.
You most likely didn’t have to think too much about which income would be taxed during your working life, because it would generally be your earnings. And it’s possible you’re aware that, despite the fact you can still be charged Income Tax in retirement, you’ll no longer have to pay National Insurance contributions after reaching State Pension age.
On the other hand, Tony Clark, Senior Propositions Manager at St. James’s Place Wealth Management, observes that the tax situation is suddenly somewhat different in other ways too.
“From a tax perspective, you can now control much more about how you take your income and how much tax you pay. You could well have pensions, Cash ISAs, Stocks & Shares ISAs, property, earnings and so on. But how you extract money from that, and use it as income, is treated and taxed differently.”
The best course of action won’t always be clear-cut. For many people who are weighing up where to take an income from once they’ve hit retirement, the point of departure will be their pension. However, whereas the first quarter of your DC pension pot can be taken tax-free, people often fail to remember that anything exceeding that 25% will be taxed at your marginal rate. With this in mind, the way the pension is taxed makes it worth your while looking into other options.
For instance, income from your ISA won’t be taxed – this offers the flexibility to take your income from one place over another, or to have a mix.
“A lot of people don’t necessarily realise this. They’ll rely heavily on a pension income that’s taxed, perhaps because they’re not aware of other ways of doing it. This is where an adviser can step in and help you, simply by knowing which levers to pull.”
There are many other tax-related perils to watch out for in retirement. Ever since the reforms of 2015, a number of individuals have been tempted into taking a lump sum from their pension pot (beyond the tax free cash lump sum) without realising it would be treated as income. This then meant they had to pay ‘emergency tax’ and potentially receive less money than expected, or with a tax headache.
“This is purely because HM Revenue & Customs (HMRC) looks at any extraction of the capital beyond the tax-free cash as being used for income. Even if you take a £10,000 lump sum, they’ll see it as income of £10,000 and they’ll tax you accordingly. So you need to be on top of your HMRC account and ensure it’s set up correctly so they know it’s a one-off and not a regular withdrawal you’re making.”
Likewise, you could run the risk of moving into a higher tax bracket if you decide to take a lump sum from a pension pot – especially if you’re a basic-rate taxpayer just below the higher-rate threshold. Once again, this is simply because HMRC treat the lump sum as income.
“However, you could use the different tax years to your advantage here. For example, if you take £5,000 in one tax year and £5,000 in the following tax year, you might be able to stay under the higher-rate threshold.”
Steering clear of obstacles
One foolproof way of making sure you don’t pay more tax in retirement than required is to seek pension advice from someone who knows which obstacles to steer clear of.
“When you’re approaching retirement, you should speak to an adviser to ensure you’re taking income in the most tax-efficient ways, because it is quite different from how you’re taxed when you’re working.”
This tactic applies to anyone in the run-up to and entering retirement. Not only that, but it can be all the more relevant for anyone reaching retirement who has both DC and Defined Benefit (DB, or final salary) pension pots. The reason for this is that the income from a DB pension will be paid to you whether you want it or not, and it will be taxed. It’s therefore crucial to know which incomes you’re going to get regardless and which incomes you’re able to flex.
“An adviser can help you see the bigger picture and understand which of your assets are subject to which tax regime when you take money out. It’s a time of life when a lot of people want to take lump sums, and there are important decisions to make, so you don’t want to take your eye off the ball at the last minute.”
The value of an investment with St. James’s Place will be directly linked to the performance of the funds selected and may fall as well as rise. You may get back less than the amount invested.
The levels and bases of taxation and reliefs from taxation can change at any time and are dependent on individual circumstances.