How income drawdown can be utilised to create a tax-efficient pension income

Since the pension freedoms, income drawdown has proved to be a popular option for individuals who want greater control and freedom over how they access their pension savings.

However if employees go down the income drawdown route, they will need to make sure they don’t pay any unnecessary income tax. Usually 25% of a pension is tax free, and the remaining 75% is taxed as earned income – but with careful planning it is possible for individuals to pay very little income tax, especially in the early years.

WEALTH at work has created three fictional case studies to help employees considering income drawdown understand how they can utilise all their savings to create the most tax efficient retirement income. All case studies assume ISA returns of 5% and interest available on taxable cash deposits of 1.4% gross.

Case study 1
Peter is aged 60. He has a defined benefit (DB) pension (also known as a final salary pension) which will pay £8,000 pa, a defined contribution (DC) pension fund (also known as a money purchase pension) worth £300,000, ISAs worth £50,000 and £10,000 held in cash. He is planning to retire in April 2018 and would like to generate an initial annual income of £20,000 pa net and retain the £10,000 as an emergency cash reserve.

Using the method outlined below it is possible for him to do this without paying any tax in year one, even though £20,000 is almost double the personal allowance of £11,500 for 2017/18, by using his ISA and flexi-access drawdown (FAD) for income.

Peter can withdraw £2,500 interest from his ISA leaving £17,500 to find. He has a personal allowance of £11,500 so he does not need to pay tax on the £8,000 from his DB pension and consequently will have £3,500 of unused allowance available.

He therefore needs a further £9,500 to have the £20,000 income he is looking for. To be able to do this he will need to crystallise £24,000 of his DC pension using FAD, £6,000 (25%) can be taken as a tax free cash lump sum and £3,500 withdrawn as an income to utilise the remainder of his unused personal allowance. By doing this he will have the £20,000 he is looking for tax free.  £18,000 will remain in his pension as a ‘crystallised’ fund with the potential to grow and which can be drawn from in future years.

Case study 2
Mary is in exactly the same financial position as Peter, but eligible for the full State Pension. As the combined income from her DB scheme and State Pension will be higher than the personal allowance she will need to pay some tax, but will not need to pay any further tax up to the £20,000 annual income she is hoping for.

Mary has a personal allowance of £11,500. The combined income of £8,000 from her DB pension plus £8,296 new State Pension gives her a gross income of £16,296. Income tax payable on this would be £959, leaving a net income of £15,337.

To achieve her aim of an income of £20,000 a year, she can supplement this with £2,500 interest from her ISA and £2,163 tax free cash from her DC pension fund. To do this she would need to crystallise £8,652 using FAD, £2,163 (25%) can be taken as a tax free cash lump sum but £6,489 would remain as a ‘crystallised’ fund in her pension with the potential to grow.

Case study 3
David, aged 60, is looking to retire in April 2018. He is in a similar position to the case studies above except that he is not yet eligible for his State Pension, his DC pension is £200,000 and has taxable cash deposits of £100,000.

To achieve his aim of an income of £20,000 a year tax free, he could use the £8,000 from his DB pension and £3,500 from the taxable part of his DC pension fund to use up his personal allowance (£11,500). He would need to crystallise £4,667 of his pension to be able to withdraw £3,500 (75%) in taxable income and £1167 (25%) would be paid as a tax free cash lump sum (£3,500 + £1167 = £4667).

This could be supplemented with £2,500 interest from his ISA and £1,400 interest from his savings (£100,000 at 1.4%), which would not be taxed because the starting rate for savings income is £5,000. As it is better to leave as much money as possible in the tax efficient wrappers of ISA and pension David may choose to spend £3,433 from his cash deposit to make up the £20,000 he is looking for.