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Personal allowances and ISAs can help beat the taxman
Thursday 17 Nov 2016 Author: Emily Perryman

The thought of being hit with hefty taxes when you enter your golden years is a bitter pill to swallow. But you could be on the path to a tax-free retirement by making use of the available range of allowances and tax wrappers.

Charles Calkin, head of financial planning at investment management firm James Hambro & Co, says it’s possible for a couple to generate a six-figure tax-free income in retirement if they start planning early enough.

‘If you are saving heavily it is important to try to save within a tax wrapper like an ISA or pension to protect yourself from capital gains tax when you dispose of the assets. But which you prioritise depends on your particular position.

‘In simple terms a mix of pensions and ISAs spread across both partners can make a big difference to your tax position when you retire,’ he says.

It only takes a few
to ensure your savings are tax efficient

Step One: Personal allowance

You can take advantage of a range of allowances before you even need to consider how to make best use of your ISAs and pensions.

In the first instance, everyone earning under £100,000 a year has a personal allowance of £11,000. This means the first £11,000 of income received from a pension is not taxed.

In order to make full use of the personal allowance, make sure you aren’t just paying money into one partner’s pension. Even if your spouse is not working, they can save £2,880 a year into a personal pension and enjoy 20% tax relief, taking the amount up to £3,600 a year.

Step Two: Savings allowance

There is also a personal savings allowance which enables basic rate taxpayers to receive £1,000 interest from savings accounts tax-free each year; for higher rate taxpayers the figure is £500. This allowance can be useful for cash savings.

‘As we live longer, many of us need to keep more money in higher risk assets like shares and corporate bonds in later life. If we draw regularly from these invested savings it makes us vulnerable to market swings. The aim is to avoid having to sell assets at the bottom of the market – precisely the wrong time.

‘Having a prudent cash buffer in the bank that you can dip into during market lows is one way to tackle this problem. The personal savings allowance is useful as it means that at least the return on these savings is not being eroded by tax, though interest rates are painfully low,’ Calkin says.

Step Three: Dividend allowance

There is also an annual dividend allowance that lets you receive £5,000 in dividends each year without paying any tax. Both partners can use the allowance, which can be helpful if you are a business owner.

You could give some of your shares to your spouse and, because you’re married, you won’t crystallise any capital gain.

Mike Morrison, head of platform technical at AJ Bell, says if the three personal allowances are used there is scope for a basic rate taxpayer to have a tax-free income of £17,000 in retirement from a combination of pensions, savings and dividend-paying investments.

Step Four: Capital gains allowance

Morrison says you should be aware that you can realise £11,100 in capital gains each year without paying tax.

‘So someone in retirement can sell investments and use that money to boost their income without paying tax if the amount they make on the investment is less than £11,100 each year,’ he says.

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Tax benefits through your working life

It used to be the case that planning for retirement meant just saving into a pension, but this is no longer the case. ‘People can save in different tax-advantaged products throughout their working lives to give themselves a lower tax footprint in retirement,’ says Simon Ruthers, director of business development at Oxford Capital.

Pensions are still a great way to prepare for retirement because you receive tax relief at your highest marginal rate on everything you save. But when you retire, only 25% of the fund can be taken tax-free.

‘When you take benefits from the balance of the fund you will pay income tax on any amount you take over your personal allowance in retirement,’ explains Ruthers.

Become an ISA millionaire

ISAs are another effective way to build up retirement income. Although you pay into an ISA using taxed income, there is no income tax or capital gains tax levied when you withdraw money.

From April 2017, it’s possible to pay £20,000 a year into an ISA. James Hambro’s Charles Calkin says a 40 year-old who pays in £20,000 at the beginning of every year and generates 5% net compound growth annually would be an ISA millionaire by the age of 65. If both partners did this, the overall pot would be worth around £2 million.

‘Assuming your savings simply held their value thereafter, you could draw over £65,000 a year tax-free in retirement for 30 years before this money ran out. Of course, any household that can afford to save £40,000 a year in ISAs, on top of pensions, is going to be paying a fair bit in income tax now,’ says Calkin.

Death benefits

There are other benefits of using ISAs. When you die, an additional allowance equivalent to your ISA value is available for your spouse. They can benefit from the combined value of both ISAs for the rest of their life.

‘You also do not need to disclose income or gains from ISAs on your tax return, which can save you a lot of hassle. As you get older you may prefer your ISAs in bonds and these can pay income gross, which is useful for income generation,’ says Calkin.

Pensions can be passed on to beneficiaries when you die without paying inheritance tax (IHT), whereas ISAs are subject to IHT. This is another argument for depleting your ISAs before you touch your pension.

By using your personal allowances, ISAs, capital gains and 25% pension tax-free lump sum you could be well on your way to a comfortable, tax-free retirement – and cut the bill for your loved ones when you die.

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