If income withdrawal is one way in which you plan to pay for your retirement, you’ll be able to keep some of your savings invested – potentially making your money work harder and take income more tax-efficiently. But there’s always the risk that your money won’t last long enough unless you manage it carefully.
In the light of this, how appropriate is income withdrawal as a way to meet different kinds of expenditure? And what else might you consider?
Expenses such as utility bills, car running costs, insurances and food are often referred to as fixed expenditure. You have less control over this type of spending, although it is possible to make savings (see the January issue of Thinking Ahead for money saving tips).
Ensuring that your pension income is enough to cover your fixed expenditure should be your top priority. Pensions that provide a known income, such as the state pension or defined benefit (e.g. ‘final salary’ or ‘average salary’) pensions, are a good match for fixed expenditure. Some of these pensions also rise in line with price inflation, so are also good at keeping pace with the cost of living.
If you don’t have enough income from sources such as this, you could consider an annuity. These are available from insurers and provide a guaranteed income for life. If you do decide to buy an annuity, you should shop around for the best rates. Also, don’t forget to consider options such as inflation protection or adding your spouse or partner so that the income can continue to be paid to the last survivor.
Of course there are other types of expenditure over which you have personal choice and therefore control. Known as discretionary expenditure, examples include eating out, holidays or buying a new phone or camera.
You may decide that you can afford to take more risk, in the hope of better returns, with the part of your pension that covers your discretionary expenditure. If your investments don’t do so well, you can afford to cut back your expenditure to allow your investments time to recover. On the other hand, if your investments do particularly well, you may find that you are able to afford a second holiday!
Pensions that provide a fixed monthly income such as state pension, defined benefit pensions and annuities are great for covering fixed expenditure. But the income they provide is not controllable – it comes in steadily month after month.
Income withdrawals directly from your invested pension fund can be increased or reduced, and even switched off altogether if desired. This gives you more control and can be useful if you find you have unexpectedly higher taxable income during a particular tax year, or where a capital gain arises.
Irene has fixed pension income of £20,000 a year from her state pension and defined benefit pensions. She also takes income withdrawals of £5,000 a year from her self-invested personal pension fund, which remains invested in a mix of different investments. So, Irene’s total annual income is usually around £25,000.
Irene has also sold a buy-to-let she bought a few years ago and has made a gain or profit on her investment of £33,100 after taking into account selling costs. Irene is allowed to reduce the taxable gain by using her annual capital gains tax exempt amount of £11,100, leaving her with a taxable profit of £22,000.
However, when this is added to Irene’s existing annual income of £25,000, it uses up the remainder of her basic rate tax band and pushes her into the higher rate tax band, which starts when total income reaches £43,000 (tax year 2016/17). This means that £4,000 of the profit or gain is taxed at 28% and the remaining £18,000 is taxed at 18%.
However, as Irene can control her pension withdrawal income, she could reduce the income from £5,000 to £1,000. This would mean that her taxable income would be £21,000 (instead of £25,000) and the addition of the capital gains profit of £22,000 would not push her total above £43,000.
By reducing her pension income, the whole capital gain would be subject to tax at just 18%, saving Irene £400 in tax.
Passing on your pension savings as an inheritance
Another advantage of leaving your pension fund invested and taking income withdrawals is that the whole remaining fund can be passed onto beneficiaries tax efficiently.
The tax treatment of any money you pass on depends at what age you die.
- If you die before age 75, the remaining fund can be passed on – to whomever you choose – tax free.
- If you die after age 75, again you can pass your pension to anyone of your choosing, but they must pay income tax on withdrawals they make from the inherited pension, at their highest marginal rate.
These rules make pensions an attractive way to pass money onto the next generation, because pensions are generally free of inheritance tax.
It’s important not to forget other assets which form part of your estate, and are potentially subject to inheritance tax. These include the family home, investments and savings such as ISAs and bank accounts and personal effects such as jewellery or art. You can use special allowances to reduce inheritance tax, such as the ‘nil-rate band’. This allows you to pass on the first £325,000 of your estate tax-free.
If, having used your inheritance tax allowances, part of your estate remains taxable, then rearranging your savings so that more of your wealth sits inside your pension could be something worth looking at.
Although there are no restrictions placed on who inherits your pension, the discretion over who actually receives any remaining fund rests with the pension scheme trustees or managers. This discretion is the main reason that pensions generally fall outside the inheritance tax net, as the recipient doesn’t have a legal right to the remaining fund.
Pension scheme trustees and managers allow savers to provide some direction as to who should inherit their pension fund. To do this, the pension saver usually completes an ‘expression of wish’ form.
The trustees or managers usually pay the benefits as indicated in the member’s expression of wish, but they are not legally bound to follow these directions. For example, if the member’s expression of wish overlooks someone who was financially dependant on them at the date of their death, some or all of the remaining fund could be given to financial dependants rather than those named by the member.