How to pay less tax when building and withdrawing your pension
The best tip is to start early and save as much as you can, maximising the most tax-efficient savings plans.
Taking your savings in a particular order can make a big difference to how much tax you’ll pay, making your pot last longer.
It could also allow you to leave more money to your loved ones following your death. Typically, you shouldn’t take money out of a tax advantaged savings plan until you actually need the income.
You should also do what you can to avoid jumping up a tax band and paying more tax than you have to.
Everyone’s circumstances and financial needs are different and ideally you should get the help of a professional financial adviser, but here’s our ‘pensions waterfall’ – or guiding principles – to help you maximise your retirement savings.
1) Get the most on the way in, from the government and your employer, and pay less tax on the way out. Doing this will help you build up your retirement savings pot faster and make it last longer when you start taking an income.
2) If you are in a workplace pension scheme, maximise your employer’s contribution. Employers may match your pension contribution, if you pay £1, your employer may also pay a £1, up to a limit. Ask your employer for information. Employers can’t pay into ISAs or the new Lifetime ISA (LISA) available from April 2017.
3) Choose the most tax-efficient savings plan to build up your retirement income quicker. The government encourages people to save, with greater incentives to tie up savings for longer. It pays a 25% bonus into a LISA for contributions up to £4,000 a year, regardless of whether someone uses it to pay for their first home or a pension, and regardless of your tax status, eg basic, higher or additional rate so everyone gets the same.
The tax relief you get on pensions is different and depends whether you pay tax at 20%, 40% or 45%. Though for basic rate taxpayers, you get the same 25% bonus. For every £8 you pay in, the government adds another £2. Higher rate taxpayers get even more government bonus if they save in a pension, adding £4 for every £6 you pay. The government stops adding a bonus to a LISA once you reach your 50th birthday, whereas it will keep on paying a pension bonus on new contributions until your 75th birthday.
4) Don’t rush into taking money out, wait until you actually need it. Pensions, LISAs and ISAs will continue to grow tax free. Don’t take out any money, particularly from a pension just to put it into a bank account or cash ISA. This is because as soon as you take out your pension, it becomes taxable under income tax rules (excluding the 25% tax free cash sum). By putting money into a bank account or ISA, you won’t get the same returns, particularly as there are very low interest rates and your money won’t work as hard for you as it would in a pension.
5) Some savings are tax-free when you take them out. LISAs, ISAs and the first 25% of your pension fund are tax free and won’t affect the amount of income tax you pay when you draw income.
6) Never push yourself into a higher tax bracket. Remember pension income, including the State Pension, is potentially taxable. Be careful not to take out too much pension income in any tax year if you’re using income drawdown in case this pushes you into a higher tax bracket. Only take out as much money as you need. If you’re a basic rate taxpayer for every £1,000 of pension income you will get £800 in your pocket. Every £1,000 of pension income subject to higher rate tax leaves you with £600.
7) Use your personal tax allowance. If your income is less than your personal allowance (currently£11,000) you won’t pay any income tax. Think about topping up your income to your personal tax allowance from your pension.
8) Pension savings can be passed on tax-free to your loved ones. Pensions, unlike ISAs and LISAs don’t form part of your estate, so inheritance tax isn’t normally payable (although there are special tax rules between spouses and civil partners who can inherit their partner’s ISA allowance). If you die before your 75th birthday your unused pension funds can be paid tax-free to your loved ones either as a lump sum or income. Annuities can also be bought on a joint life basis to continue to your surviving partner. If you die after age 75, any unused pension fund is taxed at your loved ones income tax rate.
Kate Smith is head of pensions at Aegon.