How to make retirement less taxing

“There seems to be a presumption that anyone who has taken control of their own pension savings must be vulnerable or stupid, and that anyone choosing flexible drawdown over converting funds into an old-fashioned annuity is prone to making mistakes,” one FT reader wrote to me.

But the evidence is that “drawdowners” are not foolishly raiding their pension funds. HM Revenue & Customs’ statistics show average withdrawals per person have remained largely the same over the past three years, at just over £7,000 per quarter. That’s even through a cost of living crisis.

Nevertheless, many drawdowners may be missing a trick or two, when taking income against the backdrop of the government’s six-year freeze in income tax thresholds. Jeremy Hunt is not expected to reverse these in next week’s Autumn Statement.

A four-year freeze in the personal tax allowance and higher rate thresholds for income tax was first announced in the 2021 Budget. In last year’s Autumn Statement the policy was extended through to 2027-28.

Abandoning the usual uprating of tax thresholds is a tried and tested way for governments to raise revenue in a stealthy way. This amounts to Britain’s biggest tax rise on incomes in at least 50 years, according to October’s analysis from independent think-tank the Resolution Foundation. However, with some careful planning, you can bring your tax rate down.

First, understand pension taxation. Once you turn 55, you can withdraw up to a quarter of your pension tax-free, to a limit of £268,275. Those who previously applied for “protection” may be entitled to a higher tax-free lump sum. The remaining 75 per cent of the pot can then be moved to a drawdown plan, used to buy an annuity or taken as cash. Whichever way you choose to receive this portion of the money, it’s classed as income, so subject to income tax.

Giving you access to a nice nest egg with no tax liability, the pension tax-free lump sum can be a great option for those who use it wisely. Ian Millward, director of Candid Financial Advice, points to the “flexibility to draw from either the tax-free pot, the taxable pot or even a blend of the two”.

If you have unused personal allowance, worth up to £12,570, you may decide to draw taxable income to make up the difference. But if you are sitting on the cusp of an income tax band, beyond which your tax rate rises, you may choose to draw tax-free cash. For those with savings income, pension income above the personal allowance of £12,570 will reduce your £5,000 tax-free savings allowance, in which case tax-free cash is preferred. 

Similarly, Doug Brodie, founder and chief executive of Chancery Lane Retirement Income Planning, says: “The maths is simple — if you have full state pension of £10,602, you have £1,969 tax-free allowance left. Income above that is subject to income tax.” But he says if you “slice” the pension and take £2,625 per year, then you still pay no income tax because £1,969 is under the allowance, and the £656 is the tax-free cash.

For those wanting to draw higher income from their pension pot, the opportunity to reduce the tax burden is helped by the much-improved environment for generating an income from investments. With UK interest rates now at 5.25 per cent, up from 0.1 per cent throughout 2021, investors can finally generate a meaningful income.

Ben Klein, senior wealth manager at Tideway Wealth, says: “Even though tax takes are higher with frozen allowances, the extra income yield we can generate today means we can lower marginal tax rates and consume less of our capital to generate the same ‘net of tax’ income stream.”

Tideway gives the example of John, who is 56, married, and would like to draw an annual income of £40,000 after tax. He has a self-invested personal pension (Sipp) worth £1.3mn and individual pension protection that allows him to take a tax-free lump sum of £280,000.

The example relies on a second individual savings account (Isa) allowance being available. Many people with spouses often forget that as a couple they can put a combined £40,000 into Isas each tax year, from which they can draw a tax-free income.

Drawdowners should also consider gilts as a way to invest tax-free cash

John moves £80,000 of the tax-free lump sum into Isas, spreading this between his wife’s and his allowances, over two tax years. They invest the remaining £100,000 each into taxable general investment accounts (GIAs).

Compare the income in January 2021 with what it would be now. The Isas in 2023 would generate £5,200 today — up from £3,200 in January 2021, when the yield was 4 per cent versus 6.5 per cent now.

The income from the GIAs is now £8,000 — up from £4,000. Although John and his wife now have to pay dividend tax of £525 (assuming she is a basic-rate taxpayer), the combined income from the Isas and GIAs is still higher.

This means John now only has to draw an income of £31,014 gross from his Sipp to get to his £40,000 desired income, rather than £37,875 in January 2021. John therefore pays less tax on his pension income and, despite a higher tax environment, his overall tax rate drops from 11.3 per cent to 9.5 per cent.

Drawdowners should also consider gilts as a tax-efficient way to invest tax-free cash. Brodie describes them as “armour-plated safe” and, importantly, free from capital gains tax. You could put together gilts maturing at different stages (quarterly, half yearly, annually) — so they mature in each period. “Such ladders are only going to increase in use,” he says. 

This week you could buy the 31/1/2025 0.25 per cent gilt at £94.82. All gilts are redeemed at £100, so the holder will get a tiny coupon (0.25 per cent) on which income tax will be levied, but then a £5.18 tax-free capital gain in Jan 2025 (5.18 divided by 94.82 is 5.46 per cent, the return). The 0.125 per cent 30/01/2026 gilt is priced at £91.32, giving a gain of £8.68 tax free in January 2026. (8.68 divided by 91.32 comes to a return rate of 9.5 per cent). 

You may want to take some shrewd advice from a professional. In this case, initiating a discussion around lowering your marginal tax rates or creating a gilt ladder is a great way to find out if they know their onions. 

Moira O’Neill is a freelance money and investment writer. X: @MoiraONeill, Instagram @MoiraOnMoney, email: moira.o’neill@ft.com.