Why tax really matters in retirement


Julie Hutchison

27th May 2015 at 10:56am

This could be the most important article you read this year, if you’re about to start taking money out of your pension savings.

Being ‘savvy’ with tax is one of the most important factors which can help you make the most of your pension savings.

I’m going to share a case study with you which shows just how big an impact tax can have to help you understand why you shouldn’t ignore it.

Let’s say we have Alice, who is 60 and volunteers part-time in a local museum. Alice has £100,000 in her pension pot and £30,000 of ISA savings. Alice is married and her spouse has considerable savings, meaning that she is not solely responsible for funding her retirement lifestyle. Their twin children are about to start university in the same city and she is thinking of helping them buy a flat, covering the deposit and other purchase costs of £60,000.

Scenario 1: Taking a lump sum from your pension can be costly

The first 25% of her total pension savings could be tax-free cash of £25,000. Alice still needs another £35,000.

The next £10,600 would be tax free, within her personal allowance for tax year 2015-16. This leaves £24,400 of taxable income to generate from her pension.

But Alice needs to withdraw more than £24,400 to take account of the tax due. If she took out £30,500 she would be left with £24,400, allowing for basic rate income tax of 20% to apply. Assuming Alice had no other income this tax year, her final income tax bill in this scenario would be £6,100.

But by taking this large lump sum from her pension in one go, the emergency tax code will apply. This means £16,942 in extra tax would be deducted upfront leaving Alice to reclaim this from HM Revenue and Customs. While her final tax bill is still £6,100, that’s only the case after she claims her tax refund.

Scenario 2: How Alice ends up paying no tax

Alternatively, Alice might choose to cash-in her ISA savings first. Withdrawals from an ISA are tax free and this covers the first £30,000 of what she needs.

The remaining £30,000 could come from her pension. As we saw in the first scenario, Alice can take 25% tax-free cash from her pension, funding the next £25,000. And the final £5,000 of income she takes from her pension would be within her personal allowance and is not taxable.

In this scenario, Alice has no income tax bill at all – although, as before, an upfront income tax bill will be generated by the emergency tax code, which could then be reclaimed.

Tax matters. Both scenarios enable Alice to fund the flat she wants to buy for their children. But the decision she makes could result in a final tax bill of more than £6,000, or no tax bill at all.

Tax can be tricky and I’d recommend you speak to an expert to help you stay on track.

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This blog and any responses to comments are not financial advice. This blog is only an illustration and other approaches are possible. Tax and legislation can change in the future and this represents our understanding of the rules in May 2015