Important information -  the value of investments and the income from them can go down as well as up, so you may get back less than you invest.

The pension freedoms introduced almost a decade ago not only freed you from the need to buy an annuity: they also gave you great flexibility over how to use your pension savings. And that flexibility, if used in conjunction with other tax-efficient tools such as ISAs, gives you great scope to minimise your tax bill. Specifically, it can help you avoid the higher-rate tax band, even if your total income comfortably exceeds the £50,271 threshold for the higher rate.  

If you make full use of the tax-planning tactics available to you, you could earn £60,000, £70,000 or even more annually and still never pay more than the basic rate of tax. 

Here are the three key tools at your disposal. 

This article is not financial advice; instead it outlines ideas for planning your retirement income that you may find useful, taking into account your own needs and circumstances. 

1. ISAs 

There is no limit on the amount you can have in your ISAs so there is, in principle, no limit to the tax-free income they could produce for you in retirement. For instance, if your taxable income from sources such as the state pension and your private pensions was £50,000 a year and you had £200,000 in ISAs, you could withdraw £10,000 a year from the ISAs every year for 20 years (or for longer if we include any investment growth). This would take your total income to £60,000 a year, yet you would never pay the higher rate of tax. The income you take from ISAs is simply outside the scope of the tax system, so there would be no need to fill in a tax return; if you did need to fill one in for other reasons, you would not need to declare your ISA income.

2. Using the tax-free portion of your pension

We are used to hearing about the ‘tax-free lump sum’ of 25% of your pension pot but there is no need to take it all as one lump sum – you can spread it out over as many years as you want, so that it effectively becomes an additional source of annual tax-free income. This course of action may be especially suited to those who have no specific use in mind for the tax-free sum, such as paying off the mortgage. If you do take a portion of the 25% tax-free sum every year, that income, along with income from ISAs and your state pension, could be enough to keep taxable withdrawals from your pension below the higher-rate threshold. 

Under the rules, there are two ways to make regular tax-free withdrawals from your pension. The first is to divide your pension into distinct pots, from each of which you can take 25% as tax-free cash (the remainder can provide a taxable income or be left in the pension to grow). The second method has the same effect but is specifically designed to allow you to make regular withdrawals as a mixture of taxed and tax-free income. This method goes by the unlovely name of UFPLS, which stands for ‘uncrystallised funds pension lump sum’. This withdrawal method means each withdrawal will contain a mixture of tax-free and taxable money. In a simple example, if you withdrew £10,000 via UFPLS, £2,500 (25%) would be tax-free and £7,500 would be classed as taxable income. Your pension company will be able to help you set these arrangements up. 

3. Flexible drawdown options

The ‘pension freedoms’ that took effect in 2016 didn’t just introduce UFPLS; they also gave pensioners complete flexibility over how much, or how little, they could withdraw from their pots each year. The freedoms allow pension savers to treat their pension pots as bank accounts from which they can withdraw as much or as little as they want, when they want, subject only to tax once any tax allowances and the 25% tax-free cash have been used. It is therefore open to savers to add up their income from other sources and then take the precise amount from their pension that will keep their total taxable income below the threshold for higher-rate tax. 

Let’s look at a simple example where, ignoring any investment growth and inflation, you want to make your money last 20 years. Say you have a pension pot of £750,000, ISAs of £200,000 and the full state pension of £12,005 a year. You take a 20th of your ISA each year, which gives you an annual income of £10,000 tax free, and likewise take a 20th of your tax-free cash from your pension annually for an income of £9,375 a year (25% of £750,000 = £187,500 total tax-free cash and then divided by 20). All this income is outside the scope of the tax system. The higher-rate tax band starts at £50,271. Therefore, you can take £38,266 taxable income from your pension (£50,271 minus £12,005 state pension). Add to this your £10,000 (ISA), £9,375 (tax-free cash) and £12,005 (state pension) and your total income comes to £69,646.

The annual tax bill is £7,540 so your effective tax rate (your tax bill divided by your total income before tax) is just 10.8%. 

Other tools at your disposal

We’ll briefly mention a couple of other ways to generate tax-free income in retirement. 

Gilts – bonds issued by the British government – attract no capital gains tax at maturity or sale. A strange side-effect of the financial crisis is that this makes certain issues of gilts virtually tax-free savings vehicles (they paid almost no interest, so market forces have made them trade below face value; when sold they will therefore produce a capital gain, which will be tax free). You could buy gilts outside a tax shelter such as an ISA and cash them in in retirement to add to your tax-free income. 

Venture capital trusts, a type of investment trust dedicated to funding start-ups, pay tax-free dividends even outside ISAs and pensions. They tend to be more volatile and riskier than other funds, however. 

The government’s rent-a-room scheme allows you to let rooms in your home and earn rent of up to £7,500 a year tax free. 

The government’s Pension Wise service offers free, impartial guidance to help you understand your options at retirement. You can access the guidance online at www.moneyhelper.org.uk or over the telephone on 0800 138 3944. 

Our retirement specialists can provide you with free guidance to help you with your decisions. They can also provide advice and help you select products though this will have a charge. 

This article is one of a series on retirement income. The other articles are here:

If you’ve got a burning question you want to ask, why not drop us a line. Ask us your question.

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Eligibility to invest in an ISA or SIPP and tax treatment depends on individual circumstances and all tax rules may change in the future. Withdrawals from a pension product will not be possible until you reach age 55 (57 from 2028). This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.   

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