Create your own retirement tax haven in the UK: Pensioners can receive £27,227 tax-free every year

Increasing numbers of higher-earning workers in the UK are becoming used to paying more tax at higher marginal tax rates. The Office for Budget Responsibility estimates that 2.5 million workers will be drawn into the higher and additional rate bands by 2027/28.

Frozen thresholds and the concept of ‘fiscal drag’ are becoming facts of modern-day financial life – and by and large are a pill to be swallowed as incomes increase through a career lifetime. A consolation for earners of a higher income tax environment is that they can take advantage of tax relief to boost their pension saving.

But even in retirement the tax burden is spreading and growing, in a double whammy with the much-elevated cost of living. The OBR recently estimated that in the tax year 2023/24 there are 8,1million taxpayers of state pension age compared to 6.47million in 2020/21 - a 25% increase over just three years.

With retirement funds, however, savers can take a more proactive approach to tax efficiency. Even the majority who envisage paying only the basic rate on their pension income can structure their finances so that their retirement assets and income will be less depleted by contributions to HM Treasury.

Gary Smith, Partner in Financial Planning at wealth management firm Evelyn Partners, says:

“With the tax burden in the UK increasing to post-war record levels this year, it makes sense to use the tax shelters that we are all entitled to.

“By keeping an eye on their exemptions and allowances, savers can make sure they are making the most of their retirement savings by not handing excess sums over to HMRC and the Treasury.

“And looking at the permafreeze and even reduction of many tax thresholds, this is a reminder not just of utilising available exemptions as carefully as possible – but also of using ISAs and structuring pension access to afford further protection against rising taxation.

“A good place to start is the number of exemptions from potentially taxable sources.”

Maximise use of exemptions – the 'tax-free max’ in 2023/24

The total annual amount that can be received tax-free from potentially taxable sources in the UK totals £27,277 in the current tax year. This encompasses income generated from work or pension, savings interest, dividends and capital gains.

It does assume one’s assets are arranged in such a way as to maximise the use of all available tax exemptions, and requires substantial savings and investments.

Smith says: “Most allowances are dwindling rapidly in real if not nominal terms, but it is still currently possible for a retiree to enjoy an annual income of £27,227 without paying any tax at all.”

1. Personal tax allowance: An individual in retirement with the full state pension of £10,600 per annum, can receive a private pension income (from an annuity for instance) worth £1,970 a year before they hit the personal tax allowance of £12,570.
2. Pension tax-free ‘lump sum’: The 25% tax-free element of a private pension pot does not, contrary to common perception, have to be taken in one go as a lump sum. Alternatively, as income is taken from the pot each year, 25% of each withdrawal can be taken tax free – and this can be useful in minimising one’s overall tax burden. Someone wishing to pay no tax could set their annual withdrawal at £2,627 gross. Of this, 75% or £1,970 falls within the personal income tax allowance, while the remaining 25% or £657 is taken from the tax-free element of the pot.
3. Savings income: If they had substantial savings outside ISAs, a saver could then max out the starting rate of tax for savings, which is £5,000 as long as income does not exceed the personal tax allowance of £12,570.[1] The personal savings allowance of £1,000 for basic rate taxpayers means that there is potentially £6,000 in tax-free interest income available.
4. Investment income and capital gains: From a non-ISA investment portfolio, one can also draw income from dividends up to £1,000 and £6,000 in capital gains - allowances that fell in April this year and are due to halve again to £500 and £3,000 next April.
5. Trading: Finally, one can also earn up to £1,000 tax-free from casual trading like buying and selling on internet trading sites like eBay, thanks to the trading allowance.
   
   A couple can double most of these tax-free amounts by using both sets of allowances, and transfers of assets between married couples and those in civil partnerships does not trigger tax liabilities, allowing flexibility to achieve tax efficiency.

The importance of pensions and ISAs

The 25% ‘tax free lump sum’ is a well-documented tax benefit of private pension saving. As we have seen, a drawdown strategy can also be calculated to keep annual income below a tax threshold – whether that is to avoid entering the basic, higher or additional rate bands.

Smith observes: “For many pension savers the tax benefits of reliefs at the contribution stage outweigh the tax paid at access, even if they withdraw taxable amounts. This is most obviously and commonly the case where a saver received tax relief on their pension contributions at the higher or additional rate, but then pays tax at a lower rate when they come to draw a pension income.

“That, on top of the 25% tax-free lump sum, all goes to make pensions very tax efficient.

“Even those who pay the same marginal tax rate at access that they received relief at during the contribution phase receive some tax benefit. Tax relief at the top marginal rate applies to all of each monthly contribution, whereas on drawdown or annuity income the marginal rate applies only to a portion.

“Pension savers also benefit from an investment boost, as investment returns are being earned from gross contributions. However, it is also possible that thanks to investment growth of a pot, more tax is paid on access.“

For protecting savings from income and capital gains tax, while retaining access and flexibility, ISAs come into their own. Smith says: “The narrowing opportunities for tax-exempt income and capital gains highlights the growing importance of ISAs in sheltering investments from dividend and capital gains tax.

“The annual £20,000 ISA allowance is a ‘use it or lose it’ one, and there is no guarantee a future government will not reduce that, so it is worth considering before the end of each tax year whether funds – which can be held as cash even in an investment ISA - can be committed to securing this allowance.

“ISAs provide a more flexible savings option to personal pensions, but if they remain untouched into retirement ISA savings will provide a very useful tax-free supplement to pension income, which may also be useful in keeping pension withdrawals in lower tax bands.”

Tax-efficient investments

More sophisticated investors can seek tax-free dividends from specialist investments such as Venture Capital Trusts and tax-deferred withdrawals from offshore investment bonds.

Investment into a VCT new share issue provides a 30% income tax credit on the amount subscribed (repayable if the shares are sold within five years) and any dividends paid by the VCT are tax-free and most VCTs prioritise dividends as the main way of delivering returns to investors.

Smith says: “An offshore bond is a wrapper for investments or other assets that is not subject to capital gains tax. Gains can grow over time without any immediate tax charge, and you can withdraw up to 5 per cent of the total amount paid into the bond each year. Because this is classed as ‘return of capital’ rather than income, there is no tax to pay.”

However, tax will be due when the capital is eventually accessed and that together with the fact that using offshore bonds, which come with fees, can be a complex affair means that they are something that should be approached with advice and expert help.

Smith says: “Offshore bonds tend to be useful mainly for those who have used up all of their annual pension and ISA allowances – for instance those who are subject to tapered relief during their earning years – and are looking for a tax-efficient way to invest that could also have tax benefits at access in retirement.”

NOTES

[1] For every pound that income exceeds the personal income tax allowance, the starting rate of tax for savings reduces by the same, until no savings allowance is left when income hits £17,570.