One of the key stages of retirement advice is to understand the different tax wrappers the client has and the tax implications associated with drawing income from them. Indeed, our calculations show that your clients could waste up to £19,700 of tax free allowances in the 2018/19 tax year by taking their retirement income solely from their pension, which not only reduces the amount of money they have to spend in retirement, but also the amount they have to leave to loved ones in the future.
While tax planning will certainly be part of your BAU process already, it’s important to note that pension freedoms have changed the ways in which your clients can access their money and in turn their advice needs. The key here is ensuring that you understand these client needs and you tailor your recommendations accordingly. This will then give you a tangible way to show how much your advice has saved them.
Using a tax policy framework will help you to establish clear repeatable processes which aim to provide tax efficient income and investment growth for your clients in retirement, and will help you to:
Using a tax policy framework will help meet your clients’ spending needs in retirement in a tax efficient way and secure the greatest inheritance for their loved ones. This can be done by:
For couples this could also mean spreading savings and investments between each party to ensure both sets of allowances are utilised, doubling the amount that can be taken tax free. Married couples and civil partners can transfer assets (for example, shares, investment bonds) to each other without generating a tax charge on transfer.
Ensure sufficient funds can be accessed tax free in case of emergencies. This could be achieved by retaining sufficient funds within ISAs or by using tax free cash from uncrystallised pension funds.
Meet spending needs by considering the full range of your client’s savings and investments, not just their pension savings. This could include withdrawing from capital resources rather than income alone.
Maximising the use of tax allowances reduces the tax payable in retirement and improves the sustainability of your client’s savings to meet their spending needs. For couples, that could mean spreading investments between each party to ensure both sets of allowances are used and could double the amount that can be taken tax free.
If there are still unused allowances after the required income has been met, the excess can be used to top up tax privileged savings such as pensions and ISAs. The key allowances and their impact on the tax policy are as follows:
|Income tax (for tax year 2018/19)||Tax strategy|
|1. Personal Allowance
Income of up to £11,850 per annum can be received free of income tax. This allowance is reduced once total income exceeds £100,000.
Earned income (including pension and rental income) will use the allowance first. If not used the allowance will be lost.
|Income up to the allowance should always be extracted. Typically the order of tax wrapper to take taxable income would be:
|2a. Savings rate band
Savings income (which includes interest and offshore bond gains) of up to £5,000 can be taken tax free in addition to the personal allowance of £11,850. But the £5,000 allowance is reduced if earned income exceeds the personal allowance. So for example, if total pension income was greater than £16,850 the savings rate band would be lost.
|The savings rate band allows gains from offshore bonds to be extracted tax free. And unlike most other forms of savings income the timing of gains from offshore bonds can be controlled to coincide with tax years when there is little or no other income. When combined with the personal allowance it takes gains of up to £16,850 out each year.
But this amount will be reduced where there is earned income such as fixed pension income (e.g. state pension, DB pensions and annuities) which cannot be stopped once in payment. So where there are offshore bonds in the portfolio, deferring fixed pension incomes can create a window to extract offshore bond gains tax free.
It is only the investment ‘gain’ from the offshore bond which is taxable. But the withdrawal will also contain a return of the original capital which is not taxed, and can be used to meet spending needs or reinvested.
For example, if an offshore bond has grown by 25% since investment (assuming no previous withdrawals have been taken) segments to the value of £50,000 could be surrendered of which the taxable gain would be £10,000.
|2b. Personal savings allowance
The first £1,000 of interest became tax free (£500 for higher rate taxpayers). Interest paid by banks and building societies is paid gross so that non-taxpayers no longer have to reclaim tax deducted at source. Additional rate taxpayers do not benefit from this allowance.
|3. Dividend taxation
The first £2,000 of dividend income is tax free. For example, a £100,000 portfolio with a dividend yield of 2.0% will not be liable to any income tax. It means higher and additional rate taxpayers will pay no tax on their dividends within the £2,000 allowance.
Dividends in excess of the allowance will be taxed at 7.5%, 32.5% or 38.1%. Basic rate taxpayers will now be subject to income tax at 7.5% on dividends over £2,000.
|Income levels should be managed so that dividend income falls within the £2,000 dividend allowance.
The dividend allowance offers the opportunity to build up further largely tax free savings in addition to their ISA, simply by using the allowances available. This can be achieved by keeping dividend income to below £2,000 pa, and realising capital gains annually from their portfolio within the annual CGT exemption (£11,700 for 2018/19).
The portfolio value at which no tax will be due will of course depend on performance.
The following tables detail the rates of tax paid and bands in the UK and different rates apply where the individual lives in Scotland.
|Nil rate||Basic rate||Higher rate||Additional rate|
|Income tax||0% < £11,850||0% < £11,850
20% > £11,850 - £46,350*
|0% < £11,850
20% > £11,850
40% > £46,350
|20% < £34,500
40% > £34,500
45% > £150,000
|Savings Rate Band||£5,000||£5,000 reducing to nil**||Nil||Nil|
|Personal Savings Allowance||n/a||£1,000||£500|
*The personal allowance is reduced by £1 for every £2 of 'adjusted net income' over £100,000. Therefore, the personal allowance is lost once income exceeds £123,700 (2018/19)
**The savings rate band is reduced on a pound for pound basis when earned income exceeds the personal allowance. Therefore, no savings rate band is available if earned income exceeds £16,850.
Figures and example based on UK income tax rates. Figures may differ for Scottish tax payers.
Your client’s spending needs in retirement can also come from their personal portfolio holdings. Similar to offshore bonds, the withdrawal will be part ‘gain’ and part ‘return’ of original capital. It is only the gain element which is subject to CGT. The first £11,700 of capital gains can be taken each year tax free.
Withdraw sufficient capital each year to use up but not exceed the annual CGT exemption.
Any amount in excess of your client’s income needs can be reinvested into:
In years where the portfolio (or specific funds) has suffered a loss, these could be realised and repurchased through pension or ISA and losses could be carried forward to offset future capital gains. But where there are both gains and losses in the same tax year, the amount of loss to be carried forward must first reduce the gains in the tax year to zero.
Most clients income needs can be managed within available tax allowances. However, some clients will need more retirement income than can be provided within their available tax allowances, meaning that some tax will be payable. For example, this may be because fixed income already in payment (such as rental income, DB or state pension) has used up both the personal allowance and savings rate band. These clients’ more complex tax affairs require a more bespoke tax planning service.
Any income shortfall could, for example, be made up from your client’s ISA without creating any additional tax (and reducing their estate for IHT). Whilst this gives the most immediate tax efficient solution, it will only be sustainable until the ISA is depleted. If a similar income is likely to be needed for a longer period, your client may end up paying higher rate tax in the future on pension withdrawals (through having no other more tax efficient sources of income to draw on). Consideration should therefore be given to paying some tax now at basic rate, to avoid paying unnecessary higher rate tax later. The client’s goals and circumstances will be critical to your approach, including:
Surrendering offshore bond segments to provide the required income can limit any exposure to tax at higher rates both now and in the future. Withdrawals will benefit from top slicing relief and it may be possible to surrender just enough segments to keep the top sliced gain within the basic rate band. This will also reduce the estate for IHT.
Withdrawals from client’s Personal Portfolio (GIA) can be taken to make up the shortfall. Any capital gains will be taxable at 10%, which is lower than the equivalent income tax rates. These withdrawals will also reduce the estate for IHT.
The additional withdrawals required can be taken from the client’s ISA (subject to the emergency fund). There will be no tax payable on these withdrawals. The withdrawals will also reduce the estate for IHT.
Flexi-access drawdown can be taken from the pension to provide additional income. This withdrawal will include 25% tax free cash. Using other sources of withdrawal before accessing the pension should preserve the pension fund which could then be passed on tax efficiently.
This is likely to preserve more wealth than solely exhausting other savings pots such as ISAs, Personal Portfolios (GIA) and offshore bonds first. But this strategy is highly dependent on how long the income will be needed and how far into higher rate tax it falls. The personal circumstances of each client will determine the relevant strategy to adopt. Wealthier clients’ circumstances are likely to be more complex and will require a more bespoke service.
Maximise the use of tax privileged wrappers to reduce any tax drag on future investment returns by moving savings between tax wrappers in retirement.
Investments where income and growth are tax free within the fund will generally give a better return and consequently could improve income sustainability during retirement.
Take withdrawals from savings which pay tax on their investment returns before tax free savings such as pensions and ISAs. Maximise tax privileged wrappers by moving savings from tax wrappers which have net returns to tax free returns where contribution limits allow. This helps to reduce any tax drag on future investment returns.
Retain investments which will provide the greatest tax efficient inheritance for loved ones. This could include taking withdrawals from investments which form part of the estate for IHT before those which do not.
Clients who have saved enough to meet their income needs in retirement may be concerned about how to provide the best possible legacy for their loved ones. This may have a strong influence on how income is taken in retirement, especially if clients have an inheritance tax liability.
The new pension death benefit rules for DC pensions mean that pension wealth is now far more inheritable, with reduced tax charges and greater freedom over who can inherit.
Where inheritance tax is a concern, it is preferable to take withdrawals from assets which will form part of your client’s estate over those that sit outside of their estate on death. Unlike most other investments, pensions are generally free of IHT and therefore withdrawals should be taken from other savings before pensions.
Conventional wisdom is to exhaust tax free cash entitlement by age 75 (as it’s lost on death after that age). However, where the client doesn’t need the tax free cash and IHT is the primary concern, leaving it undrawn within the pension may give a higher inheritance. The beneficiary may pay less in income tax to access their inherited pension than would be paid in IHT outside the pension wrapper. And the funds could become tax free again if cascaded within the pension wrapper to future generations. Alternatively, the tax free cash could be reinvested into another tax wrapper, such as an offshore bond, and held in trust for the next generation. This would fall outside your client’s estate after 7 years. The personal circumstances of each client will determine the relevant strategy to adopt. Wealthier clients’ circumstances are likely to be more complex and will require a more bespoke service.
Obviously, each client’s needs and requirements will probably not stay the same throughout their retirement. Many things can change, from their goals and aspirations to their health and life expectancy. Regulatory changes might also affect your original advice, particularly around tax.
It is more or less impossible to plan for most of these things. Therefore, your client should make time to meet with you once a year to look at the agreements you have in place, and be sure that these still meet their requirements. At that meeting, you can simply repeat the steps set out in this module, and then give your client an updated set of agreements.
The order of taxation has a bearing on which income falls within allowances and the rates of tax payable on income or gains in excess of the allowance.
Figures and example based on UK income tax rates. Figures may differ for Scottish tax payers.
Capital gains will sit on top of all other income to determine the rate CGT is payable on gains in excess of the annual exemption. Taxable gains which fall within the basic rate tax band are subject to CGT at 10%; gains over the higher rate threshold will be taxed at 20%. Capital gains from the sale of buy to let properties will continue to be taxed at 18%/28%.
Once you have implemented your tax policy, you will need to show your client your recommendation. You may already have your own recommendation report/suitability letter that you can use for this. If you prefer, you can use this tax policy statement template to create something specifically to your own tax policy. This wording has been prepared as a general style and is for information only. You should satisfy yourself as to the appropriateness for your clients and ensure that it is kept up to date and meets your requirements. No responsibility is accepted by Standard Life for any specific problems caused by reliance on, or use of, this general style which is used at your own risk:
Tax policy statement template (Doc, 76KB)
Please complete the self-assessment questions in your workbook. You can check the answers yourself at the back of the booklet