How to use Income Drawdown to minimise tax

3rd March 2015

There are many advantages to choosing to use income drawdown to access your pension, one of the main ones being able to access your assets in the most tax efficient manner.

WEALTH at work has created three fictional case studies that demonstrate how individuals can look holistically at all their assets (pension and non-pension) to create the most tax efficient retirement income and in some cases, making it possible to pay very little income tax in the early years .

Jonathan Watts-Lay, Director, WEALTH at work comments, “Making income drawdown available to all is good news for those approaching retirement, however it is likely that many will end up paying more tax than they need to. This new pension world is all about looking at all assets to provide retirement income and to ensure they are accessed in the most tax efficient way. It is important to utilise your available tax allowances and reliefs in a structured manor to maximise returns and reduce, or even eliminate, a potential tax charge.”

All of the case studies have similar situations to make it easier to see how the process works, but case study 1 and 3 are not yet eligible for their state pension and case study 3 has a smaller pension pot, but more taxable savings. All case studies assume ISA returns of 5% and interest available on taxable cash deposits of 1.4% gross.

Case study 1

Peter is aged 60. He has a Defined Benefit (DB) pension which will pay £8,000 p.a., a Defined Contribution (DC) pension fund worth £300,000, ISAs worth £50,000 and £10,000 held in cash. He is planning to retire in April 2015 and would like to generate an initial annual income of £20,000 p.a. net and retain the £10,000 as an emergency cash reserve.

Using the method outlined below it is possible for him to do this without paying any tax in year one, even though £20,000 is almost double the personal allowance of £10,600 for 2015/16, by using his ISA and flexi-access drawdown (FAD) for income.

Peter can withdraw £2,500 interest from his ISA leaving £17,500 to find. He has a personal allowance of £10,600 so he does not need to pay tax on the £8,000 from his DB pension and consequently will have £2,600 of unused allowance available.

He therefore needs a further £9,500 to have the £20,000 income he is looking for. To be able to do this he will need to crystallise £27,600 of his DC pension using FAD, £6,900 (25%) can be taken as a tax free cash lump sum and £2,600 withdrawn as an income to utilise the remainder of his unused personal allowance. By doing this he will have the £20,000 he is looking for tax free.  £18,100 will remain in his pension as a ‘crystallised’ fund with the potential to grow and which can be drawn from in future years.

Case Study 2

Mary is in exactly the same financial position as Peter, but eligible for the state pension. As the combined income from her DB scheme and State Pension will be higher than the personal allowance she will need to pay some tax, but will not need to pay any further tax up to the £20,000 annual income she is hoping for.

Mary has a personal allowance of £10,600. The combined income of £8,000 from her DB pension plus £6,029 state pension gives her a gross income of £14,029. Income tax payable on this would be £686, leaving a net income of £13,343.

To achieve her aim of an income of £20,000 a year, she can supplement this with £2,500 interest from her ISA and £4,157 tax free cash from her DC pension fund. To do this she would need to crystallise £16,628 using FAD, £4,157 (25%) can be taken as a tax free cash lump sum but £12,471 would remain as a ‘crystallised’ fund in her pension with the potential to grow.

Case Study 3

David, aged 60, is looking to retire in April 2015. He is in a similar position to the case studies above except that he is not yet eligible for his state pension, his DC pension is £200,000 and has taxable cash deposits of £100,000.

To achieve his aim of an income of £20,000 a year tax free, he could use the £8,000 from his DB pension and £2,600 from the taxable part of his DC pension fund to use up his personal allowance (£10,600). He would need to crystallise £3,467 of his pension to be able to withdraw £2,600 (75%) in taxable income and £867 (25%) would be paid as a tax free cash lump sum (£2,600 + £867 = £3,467)

This could be supplemented with £2,500 interest from his ISA and £1,400 interest from his savings (£100,000 at 1.4%), which would not be taxed because the starting rate for savings income is £5,000.  As it is better to leave as much money as possible in the tax efficient wrappers of ISA and pension David may choose to spend £4,633 from his cash deposit to make up the £20,000 he is looking for.

With all these examples, the individuals are paying the lowest amount of possible tax, keeping their ISAs at the same level (assuming the ISA grows by 5% per year) and withdrawing the remaining amount needed in a tax efficient manner from both pension and non-pension assets.

Further coverage was gained in The Telegraph and Money Observer.

For further information please contact us.