Spend your pension fund last to defend tax savings

Build up your pension and spend the rest of your available cash and investments first to keep your money out of the taxman’s clutches.

That’s the advice financial experts give to retirees worried about their heirs having to foot a big inheritance tax bill.

But anyone looking to minimize their annual income tax, or efficiently use their capital gains tax relief, could also benefit by first depleting assets held outside of a pension.

Although circumstances vary, it must be stressed. Therefore, it is best to keep the following in mind as useful general guidance, but consult a professional about your own situation.

How does spending your pension benefit your finances in the end?

Since the pension freedom reforms of 2015, more and more people are choosing to keep their pension invested in the financial markets in old age rather than receiving a guaranteed income through an annuity or a final salary work scheme.

If you put your pension savings into an income drawdown plan at retirement, any investment growth will benefit your portfolio, but will not be subject to tax unless or until you withdraw money as income.

You can withdraw 25 per cent of your pension tax-free, but after that income tax is applied to the withdrawals.

Keeping your money in a pension fund can also reduce the amount of inheritance tax your loved ones have to pay, if your estate exceeds the basic allowance or new home thresholds (see box below).

Beneficiaries pay no taxes on what is left in a retirement plan if the owner dies before age 75, or their normal income tax rate if they are age 75 or older.

Therefore, you may want to use other assets outside of a pension first if you hope to bequeath as much as possible, because full inheritance tax will have to be paid on the money once it is withdrawn from a retirement plan.

But this approach will not be beneficial in all scenarios, as it depends on your circumstances and income needs, not just the desire to avoid inheritance tax.

In what order should you spend your assets in retirement?

1) Investments held outside of Isas or other tax-efficient wrappers, such as shares, bonds, funds and buy-to-let properties, all of which could be subject to capital gains tax or inheritance tax. These can be taken advantage of gradually, using capital gains tax reliefs over time.

2) Investment and cash Isas, except those held in an AIM portfolio that qualifies for business property relief. See the chart below.

3) Homes, if they raise your estate to over £2 million, as downsizing and spending or donating the money it frees up can reduce your inheritance tax bill.

4) Investments with BPR status, which are protected from inheritance tax if you have held them for at least two years at the time of your death.

5) Pension funds are invested in income reduction schemes, because they remain a tax-efficient wrapper for your cash, like pensions in the run-up to retirement, and have inheritance tax benefits.

Check that your pension plan allows for ‘succession reduction’

“The majority of savers continue to view their pension as a vehicle to meet their income requirements in retirement, especially following the introduction of pension freedoms legislation,” says Gary Smith, financial planning director at Evelyn Partners.

‘However, this is not necessarily the most tax-efficient method of generating your income needs, as other assets (Isas, investments, savings and investment properties) should also be considered when formulating an effective income generation strategy. from income.

“In addition, when preparing a retirement strategy it is also important to take into account people’s wider financial situation, especially if inheritance tax is an issue for them.”

Smith emphasizes that you should check that your pension scheme allows for a “succession reduction”, as the old rules for shareholder pensions and personal pensions could prevent you from bequeathing them to anyone other than your spouse.

He says it is usually simple and free to convert an interested party’s pension, but some personal pensions apply exit charges and in these cases it may be worth waiting until the scheme’s retirement age before switching to one that offers estate withdrawals.

He continues: ‘Due to the introduction of inheritance relief, a person who has a pension that offers this service can now transfer their pension assets to their family, free of inheritance tax.

Martin Bamford, director and chartered financial planner at Informed Choice, says: ‘Portfolio withdrawal order is an important factor in extending the longevity of wealth in retirement.

‘Clients typically come to us with a variety of assets to meet their cash and income needs in retirement. These include pension plans, Isas, cash savings, mutual funds or shares, business assets and buy-to-let properties.

“We found that those who experience the most financially secure retirements tend to have a variety of assets, rather than relying solely on pensions.”

He continued: ‘For investors with “unwrapped” taxable investment portfolios, spending them first tends to make more sense than spending tax-favored Isa funds or using taxable pension income.

‘The availability of Annual Personal Savings Allowance, Dividend Tax Relief, Personal Allowance and Annual Capital Gains Tax Allowance offers many possibilities to earn income and make profits without having to pay tax.

‘Wealthier investors tend to prioritize inheritance tax planning and this can result in pension funds being spent last.

‘Unspent pension funds can be passed on to beneficiaries to spend tax-free if the pension fund holder dies before reaching age 75, or subject to their marginal income tax rate if the death occurs later. of 75 years.

“Keeping pension wealth out of the taxable estate for inheritance tax purposes, where it could suffer a 40 per cent tax charge, is an attractive prospect when other sources of wealth are readily available to fund retirement.”