Question: My 59-year-old spouse has a deferred pension worth £525,000 from their previous job plus other pensions adding up to £700,000 in total. What strategies are available to limit the tax we pay when we start to draw down?
Answer: Throughout our working lives we can implement various strategies to be as tax efficient as possible, and it’s the same in retirement. It’s a good move to evaluate your situation now, as it gives you plenty of time to adjust your approach if need be. A timely assessment also puts you on the front foot if you need to make changes as a result of this month’s Budget.
A deferred pension, for the sake of other readers, is simply a pension you are entitled to draw from should you choose to, or you can instead leave it invested to continue to grow further. You can access most personal or workplace pensions from age 55 but many people are still working at that age and prefer to leave their pensions to continue to accrue. On the other hand, the State pension age is now 66, rising to 67 in April 2028, so if you retire early you may need to access your personal pension to support your income needs.
You mention your spouse has £700,000 in total through separate pensions. As neither of you may be accessing these funds for potentially 10 years or so, it makes sense to consider the merits of consolidating these different pots into one place. There are many reasons for doing so, but let’s start with the most crucial: to ensure your money works as efficiently as it can to maximise your pension’s worth.
While we can’t control how investment markets perform or know how well they may do in future, we can reasonably assume a return of 5% per annum over time. A recent FTSE 100 analysis showed it returned around 6.3% a year annualised over the past 20 years, while the US S&P 500 index averages around 10% a year over the long term. Assuming a 5% return over the next 10 years, therefore, is not being overly ambitious. We should then assess an aspect of investing that we can control: what we pay in fees.
In 10 years, with your £700,000 pot growing by 5% a year, and paying 1% in total annual fees, it would reach just under £1.04m. However, if you pay all-in fees of 2% a year (this is typical with a traditional wealth manager), your funds would grow by almost £100,000 less – reaching just over £940,000. Of course, any further regular pension contributions could also boost your pot meaningfully while you continue to take advantage of the tax breaks your spouse has benefited from up until now.
Making these efficiency changes is a key benefit of consolidating different pension pots. Don’t assume your smaller pots are not worth thinking about – the value of bringing them all together could be significant. You may also find it more convenient and easier to oversee a single pot. In addition, when you are evaluating your options you can ensure that your pension portfolio is appropriately diversified across a mix of global assets to help drive extra resilience and further growth opportunities.
Later, when you and your spouse are ready to start taking money from your pensions, this is where you need to be thoughtful. In retirement, we must generally pay tax on our income, just as we do throughout life. This is based on our total income, including the state pension, and we all have an allowance of £12,570 before we pay the basic tax rate of 20%, with the higher rate of 40% kicking in at £50,270.
A crucial exercise for you to do in advance is to estimate how much you think you might need to live on to enjoy a comfortable retirement – and then to structure your income so you don’t pay any more tax than you need to.
For example, your spouse’s potential pension pot of around £1m or so could generate a sum that drives them into the higher rate bracket, while you may decide an income of £40,000 to £50,000 is sufficient for your needs. You will also benefit from the first 25% of the pension being tax free – this is a considerable sum in itself and could be spread out over a number of years before you have to pay any tax at all.
Even in retirement, you and your spouse should most likely also take advantage of the annual ISA allowance of £20,000 (£40,000 for a couple) – the funds you accrue in an ISA can then be taken as a tax-free income as and when needed. As you can see, there are a few permutations and you may find it is a complex task to juggle the options on your own. Clarity is key, and this might be easier to obtain with professional financial advice.
Taking advice now could help you to enhance the value of your assets in the years before you draw from your pension – and steer you away from costly mistakes. As well as your own State pension, you may have other savings or investments you would like to optimise. As a couple you may also wish to minimise your exposure to capital gains tax (CGT) and potential inheritance tax (IHT) liabilities. These two areas in particular (along with potentially other aspects of pension rules) may need a closer assessment after Labour’s first Budget in 14 years on 30th October.
While we don’t know exactly what areas of the nation’s finances will be impacted, we expect that better off individuals will bear more of the burden. It is therefore sensible to assess whether some scenarios could impact you and your spouse. How would you be affected if the CGT rate rises to 40 or 45%? Could your calculations for a comfortable retirement be altered if the pension tax relief is lowered substantially? Would a stricter IHT regime affect your plans for gifting money to children?
Whatever the actual outcome of the Budget, we would urge caution in making overly quick decisions since there should be time to digest any changes that are introduced and consequent action. It is reassuring that you and your spouse have a decent nest egg to build on towards retirement – and you can ensure you maximise its potential in the years ahead by taking appropriate action now as well as taking the time to consider what your needs in retirement are likely to be and how that might affect your plans.
This article was published in the i on 15th October, 2024.
Netwealth offers advice restricted to our services and does not provide independent advice across the market. We do not offer advice in relation to tax compliance, personal recommendations with regards to insurance and protection, or advise upon the transfer of defined benefit pensions. Please note, the value of your investments can go down as well as up.
