With pension freedom upon us it’s easy to see why one in ten plan to fully remove the cash from their pension fund, yet they don’t realise the tax implications.
So this week we ask: Is it possible to pull the plug, but in a more tax efficient manner?
You, like many others may be excited by the prospect of flexibility in your pension. The worry is that individuals, unaware of the tax consequences could find they end up with a lot less than anticipated – In this article we will discuss simple strategies that have been implement by others to save tax.
First, it’s best to understand how we are taxed on pensions.
Pension’s benefit from 100% tax relief; both via your contribution and investment. Since it is such tax efficient vehicle we ask clients to consider how their pension is invested. And as of April, when you reach 55, you have the flexibility to retrieve your money like a “bank account”. The only catch is the money out of the pension is taxable (aside your 25% tax free lump sum), treated as additional personal income. But you can learn how to hand less over by reading on.
Now, over and above that 25% each retiree has a personal allowance of £10,600 in the 2015/16 tax year. After the allowance your pension income is then taxed at the marginal rate of income tax:
- 20% basic rate up to £31,785,
- 40% between £31,785 and £150,000,
- 45% over £150,000
Once income tax is factored, you start to get a clearer idea of the amount you would actually take home, you may be very surprised! Take the example of our client A, who had £100,000 in his pension. He wanted to pull the plug in a single lump sum, this is how he would suffer.
The first 25%, or £25,000 in this case, is taken as a tax-free lump sum. Leaving 75% or £75,000 in your pension treated as supplementary to personal income. You can then remove £10,600 personal allowance, which leaves a taxable income of £64,400 for the year. By working out the marginal income brackets you get this:
- £31,785 is taxed at 20% = £6,357
- £32,615 taxed at 40% = £13,046
- The total tax due = £19,403
It is possible to pay as much as 60% tax.
Around 20% of the original pension has been gifted to government coffers – which would otherwise wise have gone back into pocket. So what’s the secret? Individuals can minimise their tax liabilities by withdrawing pension as income over time. Take, for instance, Client A’s same £100,000 as cash over 5 years.
A pot of £100,000 taken over five years equals £20,000 a year, £5,000 (or 25%) of which is tax free, leaving £15,000 of the pension fund as taxable income.
Remove a personal allowance of £10,600 leaves £4,400 of taxable income every year. £4,400 taxed at 20% totals £880 and leaves total income, including the tax-free cash £19,120. Notice now our income now falls only within the 20% basic rate of income tax.
The total tax due is £4,400. And by withdrawing £20,000 over five years means the retirees received 96% of their pension fund.
Dividing the pension income over a number of years makes a total tax saving of just over £15,000. It’s clear that stretching out the time frame and making smaller withdrawals makes us more tax efficient.
There is still something missing from the equation. Because while simultaneously drawing down its possible to have an investment bringing a return. Watch how now, by choosing a property investment that has a fixed return of 10%pa over the 5 years, you can put yourself in an even better position.
Assume we withdraw the same amount, and over the same number of years- leaving £4,400 as taxable income which still falls within the 20% basic rate of income tax. The tax bill totals £4,400 and leaves total income, including the tax-free cash of £95,600 (96%).
But now, because the property investment could return 10%pa, at end of year 5 we are left with £26,738.80 still in the pension pot. And an after tax total asset value of 122,338.80 – a substantial amount more than we started with!
It works because property investment accrues tax free in your pension- allowing us to alleviate the speed of draw-down. It’s so flexible! Every year you can choose how much to put aside and then the rest is re-invested. And because property returns are fixed, they don’t change over time, and as an alternative it gives investors stability and simplicity. From the outset we can calculate, the amount you could receive in full payment.
Note that all our calculations exclude a salary; a pension is supplementary to your personal income and will be taxed accordingly. Add your income to your pension and a higher portion of your money will be taxed at a higher rate.
Do you understand the implications of taking all your pension savings in one go and over a longer period? Get this right and get in touch!
We work with pension providers and new property owners across the world. This is a specialist field and there are very few experts that know the pitfalls and exactly what to look out for. The Landlord’s Pension has that experience, so talk to us today.