Recently released figures from the Association of British Insurers (ABI) show that £5.9bn has been withdrawn since the pension freedom reforms came into force in April 2015. Although signs are that the numbers of people accessing their pension is beginning to reduce, this has no doubt provided a welcome tax boost for HM Treasury. But the question remains, is relying on a pension the best retirement option?

The pension reform changes highlighted the hard-wired link between pension products and retirement. Pension products work on the principle of tax advantages up front, and tax-payable when benefits are taken, and they still remain popular for this reason.

However, perhaps it’s time to re-think the equation that “pensions = retirement”. And maybe now it’s time for individuals to start diversifying their assets more so they can take advantage of other tax allowances yet still receive an income on retirement.

Let’s look at an example:

Consider two individuals with the same retirement income needs but very different assets and tax liabilities:

Individual 1 – Bill has saved into his pension scheme for 30 years and has a fund of £500,000. This represents his sole savings and he expects to be a basic rate taxpayer. He will also receive the basic State Pension, assumed to be £7,500 per year.

Now that he has given up work he needs a replacement gross salary of £25,000 per year.

Bill could achieve this using drawdown through his pension, but his income tax bill would be £1,925 per year:

Income Amount per year Non-taxable income Taxable income Description
Basic State Pension £7,500 £7,500
Tax-free lump sum from pension drawdown £4,375 £4,375 £0 25% tax-free lump sum from £17,500 needed to be taken from pension drawdown to meet gross income need.
Income from pension drawdown gross £13,125 £0 £13,125 Pension drawdown income after tax-free lump sum taken from £17,500.
Total income £25,000
Total taxable income £20,625
Total non-taxable income £4,375
Less annual allowance n/a £11,000
Tax payable £0 £1,925 20% of £9,625
Net income £23,075

 

Individual 2 – Liz has a range of assets totalling £500,000. She will also receive the basic State Pension, assumed to be £7,500 per year and expects to be a basic rate taxpayer.

The assets she holds are:

  • pension £150,000
  • ISA £80,000
  • onshore bond £150,000
  • OEIC funds £120,000, producing dividends of 1%, £1,200 per year.

Now that she has given up work, she needs a replacement gross salary of £25,000 per year.

Using all of the assets she holds, this could be achieved but her income tax bill would be £0 per year:

Income Amount per year Non-taxable income Taxable income Description
Basic State Pension £7,500 £7,500
Onshore Bond withdrawal 5% £7,500 £7,500 £0 Maximum permissible tax deferred withdrawal.
ISA withdrawal £5,000 £5,000 £0 No tax liability on withdrawal.
OEIC fund dividend £1,200 £1,200 £0 Within £5,000 tax-free dividend allowance.
Tax-free lump sum from pension drawdown £950 £950 £0 25% tax-free lump sum from £3,800 needed to be taken from pension drawdown to meet gross income need.
Income from pension drawdown gross £2,850 £0 £2,850 Pension drawdown income after tax-free lump sum taken from £3,800.
Total income £25,000
Total taxable income £10,350
Total non-taxable income £14,650
Less annual allowance n/a £11,000
Tax payable £0 £0
Net income £25,000

 

These examples are based on current tax year rules, which may change in the future.

So, should pensions be the sole retirement solution?

We can see that two individuals with the same value of assets and the same income requirements have very different annual tax liabilities. The tax-free allowances used by Liz are available to all, but they’ve been achieved by planning, regular reviews and by buying other assets alongside pensions.

Summary

Pensions still form a key part of  individuals retirement goals, but no longer need to be the only answer. And by diversifying assets, individuals are able to reframe what retirement income means to them and potentially reduce their tax bill to boot!

 

 

Source: AXA Wealth