Your retirement is the culmination of your life’s work, so it is vital that you plan it well financially. Tax can have an impact on your money and without careful planning, it can quickly erode your retirement income. Through the following example, we show how structuring your finances carefully and taking advantage of the generous tax breaks provided by the Government could reduce the amount of tax you pay in retirement. A financial planner can help you with this.

Rachel’s case

Rachel, age 55, wants to retire at 60. Her annual salary has risen gradually in recent years and is now £160,000. Her yearly expenditure is £80,000. She expects that her annual spending will stay at this level throughout her retirement, as she does not want to compromise the standard of living that she is used to. Rachel currently has savings and investments valued at £1.9 million:

She feels reasonably confident that she has enough money to last her throughout her retirement but has not given much consideration to the amount of tax she will pay and the overall impact this will have on her money. She plans on taking 25% of her pension as a tax-free lump sum and using the rest of the pension pot to purchase an annuity. Rachel wants to live off this income along with her cash savings and ISAs.

Rachel wants to make sure that she will have enough money for the whole of her retirement and that there is some money to leave behind to her children in addition to her home, so she has contacted a financial planner.

Option 1

The financial planner uses cashflow modelling to see if Rachel’s money will last throughout her retirement if she follows her own proposal. It is evident that she will run out of money by the age of 78 and have nothing aside from her main residence to leave to her children.

The average life expectancy of a woman of Rachel’s age in the UK is 87 years*, so she could have around nine years without any income aside from her State pension and a small amount from her pension annuity. She will continue to pay tax throughout her retirement, totalling £449,484, and have no liquid assets to leave to her children.

Option 2

The financial planner looks into entirely restructuring Rachel’s finances in order to reduce her tax liability, improve her overall financial situation in retirement and reduce the inheritance tax liability on her estate.

After lengthy discussions with Rachel, it is clear that she has a reasonable tolerance for investment risk and is willing to take extra risk on a small proportion of her investments to potentially maximise tax-efficiency and growth.

It is recommended that in the lead up to her retirement she:

• Maintains a cash reserve to cover any unforeseen emergencies

• Contributes a lump sum of £160,000 to her pension now. Assuming she hasn’t paid into her pension for the last three years, she can carry forward the unused tax relief from these years. In the following four years leading up to her retirement, she pays in another £40,000 per annum (the pension annual allowance). This, along with the VCTs below, would significantly reduce the income tax payable throughout the rest of her working life. The investments held within her pension should be moved into a more growth-orientated portfolio

• Invests the remaining cash from her savings and ISAs into a growth fund**

• Invests in Venture Capital Trusts (VCTs). If Rachel invests in a VCT each year leading up to her retirement, she will receive a 30% income tax rebate per tax year on the investment (as long as she had previously paid the amount of tax being rebated and held the VCT for at least five years). The maximum amount you can invest into a VCT in a tax year is £200,000. VCTs are higher risk investments and are not suitable for everyone***

It is recommended that Rachel invests the following amounts over the years leading up to her retirement:

When Rachel eventually retires, her financial planner recommends that she:

• Sells the VCTs once they have been held for at least the minimum five year period to keep the income tax rebate and invest the proceeds into her general investments

• Draws an income from her general investments

• Takes a small amount of tax-free cash from her pension plus some taxable income but within her personal allowance

• Keeps the rest of her pension invested and passes it on to her children on her death

If Rachel follows the second option, she is not forecast to run out of money in her lifetime. She will have a pension of approximately £1.6 million to pass on to her children, free of inheritance tax. The overall amount of tax she will pay will be minimal – totalling £12,591 rather than £449,484 which would be payable if she went with the first option. By structuring her finances differently, Rachel could save £436,893 in tax.

In addition to her investments and pension tax-free cash, Rachel’s reduced tax liability will help her to comfortably meet her expenditure needs, with money still available to leave to her children. On this basis, her money would last her until the end of the projected scenario.

By leaving most of her pension invested, Rachel is likely to trigger a pension lifetime allowance charge of around £200,000. This is because the fund value of her pension is likely to exceed the £1.073 million threshold when it is tested against the allowance at the age of 75.

While this is not an insignificant sum, it is likely to be far less than the 40% inheritance tax her children would pay if she left them her non-pensionable assets on her death and instead chose to live on her pension income throughout her retirement.

Before seeking professional advice, Rachel believed that she would have enough money to fund the retirement that she wanted, but with a financial planner’s help, it became evident that she would pay a large amount of tax and ultimately not receive much of an income in her later years. Through careful consideration, it has become clear that her finances can be structured so that she will pay very little tax and ultimately have more than enough money to see her through her retirement without compromising her standard of living.

Speak to Evelyn Partners

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Important information

Nothing in this article is intended to constitute advice or a recommendation and you should not make any financial decision based on its content.

The value of an investment, and the income from it, may go down as well as up and you may get back less than you originally invested.

Examples of how tax or tax relief may apply are based on our understanding of current tax legislation. Whether any tax will be payable, at what level it is charged and whether you qualify for tax relief will depend upon individual circumstances and may be subject to change in the future.

* Source: ONS, 2019

** For the purposes of this illustration, we have assumed a growth rate of CPI +3.5%. This figure is not guaranteed.

*** VCTs are ‘pooled’ funds that are listed on the stock exchange. They invest in a range of businesses, which are normally smaller companies who are just starting out. The Government offers generous tax benefits when investing in these companies to firstly, encourage investors to do so and secondly, to compensate for the high level of investment risk taken.

VCTs are higher risk because they invest in small companies, which can struggle and fail. These companies can also be illiquid – making it difficult for the VCT manager to sell their shares. Shares in VCTs themselves also tend to trade at a discount, so you could lose money if you need to sell them at short notice. VCTs should be regarded as higher risk investments. They are only suitable for UK resident taxpayers who can tolerate higher risk and have a time horizon greater than five years. Please seek independent advice before considering these investments.

This example is for illustrative purposes only and is not a recommendation.