Save your pension and spend other available cash and investments first to keep your money out of the tax authorities’ clutches.
That’s the advice financial experts give to retirees who are concerned that their heirs will face a major estate tax bill.
But anyone looking to minimize their annual income tax or use their capital gains tax efficiently can also benefit from first reducing assets held out of retirement.
Circumstances vary, however, it must be emphasized. So it’s best to take the following with you as a helpful general guideline, but to consult a professional about your own situation.
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Retirement Plan: You may want to use up other assets outside of your pot first, if you hope to leave as many of them as possible
How does spending your retirement benefit your finances?
Since the pension freedom reforms in 2015, more people are choosing to invest their retirement in the financial markets at an older age rather than a guaranteed income from an annuity or final salary plan.
If you include your retirement savings in an income deduction plan upon retirement, the growth of your investments will benefit your portfolio, but it will not be taxed unless or until you withdraw money as income.
You can withdraw 25% tax-free from your pension, but after that, income tax is levied on withdrawals.
Keeping your money in a retirement pot can also help lower the estate taxes your loved ones will have to pay if your estate exceeds the basic or new housing allowance thresholds. See box below.
You must be worth at least £325,000 if you are single, or £650,000 together if you are married or in a civil partnership, so your loved ones have to pay 40 percent inheritance tax on assets above those levels.
But with an extra notional rental value you pass on more.
If you have a partner, own property and plan to leave money to your immediate descendants, that threshold is a combined £1 million.
However, for people whose estate is worth more than £2 million, this additional home allowance will be withdrawn gradually, at the rate of £1 for every £2 their estate exceeds this amount. They still keep their original zero rate of €325,000 each.
Beneficiaries either pay no tax on what’s left in a drawdown arrangement if the owner dies before age 75, or their normal income tax rate if they are 75 or older.
Therefore, you may want to use up other assets outside of retirement first if you want to leave as many of them as possible, as full inheritance tax has to be paid on money once it’s taken out of a withdrawal scheme.
But this approach won’t be beneficial in every scenario, as it depends on your circumstances and income needs, not just a desire to avoid estate taxes.
So in what order should you spend assets in retirement?
1) Investments held outside of ISAS or other tax-advantaged wrappers, such as stocks, bonds, funds and real estate for rent, all of which may be subject to capital gains or estate taxes. These can be tapped into gradually, using capital gains tax deductions over time.
2) Isas investments and cash, except those held in an AIM portfolio that qualifies for deduction of corporate assets. See box below.
3) Homes if they push your estate above £2million, as downsizing and spending or donating the money that comes free can lower your estate tax assessment.
4) Investments with BPR status, which are protected from inheritance tax if you have owned them for at least two years at the time of death.
5) Retirement jars invested in income deduction plans, as they remain a tax-advantaged wrap for your money, such as pre-retirement pensions, and have inheritance tax benefits.
What do financial experts say?
“Most savers still view retirement as a means of meeting their retirement income requirements, especially after the introduction of retirement liberties legislation,” said Gary Smith, Evelyn Partners’ director of financial planning.
Gary Smith: ‘Succession Drawdown’ Allows You to Cascade Retirement Assets to Family, Free of Inheritance Taxes
However, this is not necessarily the most tax-efficient method of generating their income needs, as other assets – Isas, investments, savings and real estate – must also be considered when formulating an effective income-generating strategy.
‘It is also important when drawing up a pension strategy to take into account the broader financial position of individuals, especially if inheritance tax is an issue for them.’
Smith emphasizes that you should check that your pension plan allows for ‘succession’, as the old rules for dependents’ pensions and personal pensions can prevent you from bequeathing them to anyone other than your spouse.
He says it’s usually easy and free to convert a stakeholder pension, but some personal pensions have exit charges and in these cases it may be worth waiting until the retirement age of the scheme before switching. to a pension scheme with sequential withdrawal.
He continues: ‘With the introduction of succession, a person who has a pension that provides this facility can now cascade his pension assets to his family, free of inheritance tax.
To encourage investment in smaller business ventures, the government provides people with inheritance tax protection if they hold shares in companies with “corporate property deduction” status for at least two years.
Some specialist investment firms offer schemes to help people buy shares in the right companies to lower their inheritance account.
However, investors interested in this area should note that BPR-eligible companies are on the adventurous and therefore riskiest end of the spectrum.
You should research carefully and diversify your investments so that they are not too concentrated in this area and not sufficiently exposed to other assets such as stocks of large companies, commercial real estate or corporate and government bonds.
This makes BPR a suitable succession planning tool for wealthy individuals who are either experienced investors themselves or can afford high-end financial advice, not the modestly wealthy who cannot afford to risk much of their investment pot in this sector. Read more here.
Given that an individual can build up a pension fund of £1,073,100, before potentially levied lifetime supplements, this is a valuable asset to pass on to beneficiaries while retaining their £325,000 “nil rate band” inheritance tax and potentially the ” stay-zero rate band”.’
Martin Bamford, a chartered financial planner and asset manager, and the director of Informed Choice, says: “The portfolio withdrawal order is an important factor in extending the life of assets after retirement.
“Customers usually come to us with a range of assets to meet their monetary and income needs after retirement. Think of pension schemes, Isa, savings, investment funds or shares, company assets and owner-occupied homes.
“We see that those who retire most financially tend to have a range of assets, rather than relying solely on pensions.”
He continued, “For investors with ‘unpacked’ taxable investment portfolios, it makes more sense to spend these first than tax-advantaged Isa pots or taxable retirement income.
‘The availability of the personal deduction, dividend tax deduction, personal deduction and annual capital gains tax deduction provides a lot of room for earning tax-free income and realizing profit.
Wealthier investors tend to prioritize inheritance tax planning and this can lead to the pension pots being spent last.
Unused pension pots can be passed on to beneficiaries for tax-free spending if the pension pot holder dies before their 75th birthday, or subject to their marginal income tax rate if death occurs after age 75.
“Keeping retirement assets out of the taxable estate for inheritance tax purposes, where it can be levied 40 percent in tax, is an attractive prospect when other sources of wealth are readily available to fund retirement.”
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