Maximising retirement income: A guide to tax-efficient withdrawals, including State Pension
Here's how to create a strategy to help you maximise your retirement income while minimising tax liabilities. We'll consider using income sources such as cash savings, ISAs, and even the State Pension.
Last Updated: 7 August 2024
Whether you’re preparing to retire soon, or you’ve already given up work, one of the key decisions you'll need to make is how to draw money from different sources to help fund your lifestyle.
Even though pensions might seem like the go-to for retirement income, they might not always be the most tax-efficient first choice. Below we offer a view on how much cash to hold and explain how to make tax-efficient withdrawals across multiple accounts to keep your cash and income topped up.
This article isn’t personal advice. If you’re not sure what’s right for you, please ask for advice. Pension, ISA and tax rules can change, and benefits depend on your circumstances. All investments can rise and fall in value. Pension Wise offers free and impartial guidance for over 50s on their retirement options.
How much cash to hold and where
As a rule of thumb, and regardless of your stage in life, it’s a good idea to have enough income set aside as cash each year to cover your essentials, like utility and food bills, and some extra for emergencies.
Any money in your emergency fund should be easily accessible. But it doesn’t mean you need to hold everything in the same account. You could consider keeping around 1-3 years worth of expenditure in easily accessible bank accounts. You could also consider holding some in cash ISAs to make the most of interest rates on offer and tax-efficient savings options.
Remember, inflation reduces the future spending power of cash.
In addition to your emergency fund, you should keep any planned expenses in the next five years as cash rather than investing the money. That’s because investments can fall as well as rise in value and it shelters you from needing to sell investments during a market downturn. This could be held in a number of different accounts.
Benefits of deferring your State Pension
If you qualify for the full State Pension, it will provide a decent chunk of income to rely on. You can claim yours when you reach State Pension age, which will depend on your date of birth.
If you can afford to, you might consider waiting to take it and look to other sources first. If you do the government will increase the amount you get by 5.8% for each year you delay as an incentive.
Consider your general investments next
When you need to top up your cash reserves for income, consider disinvesting your unwrapped investments first. Investments held outside of an ISA or pension aren’t usually as well protected from tax, but it can still be a tax-efficient withdrawal strategy if your gains fall within your annual capital gains tax allowance. This allows investments held in your ISA and pension to grow untouched by tax for longer.
Then (probably) ISAs
Individual Savings Accounts (ISAs) offer the advantage of tax-free withdrawals (as you’d have normally paid tax before adding the money to an ISA anyway).
If you have a Lifetime ISA, withdrawals will only usually be tax-free if used for an eligible house purchase or you start withdrawing from age 60.
With pensions, 75% of the value will normally be taxable as income when accessed. The rate of tax you pay will depend on what tax band you’re in when you withdraw.
For this reason, you could look at an ISA before your pension or vice versa. It largely depends on your retirement income needs, and tax position, at the time of withdrawal.
It can be a good idea to mix withdrawals from both your ISA and pension if you’re planning to receive an income which is more than £50,270. As any withdrawals you make from your ISA aren’t income for tax purposes, by balancing your withdrawals from your ISA and pension you might be able to stay below the higher rate tax band.
Investment can fall as well as rise in value, so you could get back less than you invest.
Discover the HL Stocks & Shares ISA
Withdraw from your personal pension last
You can access most personal pensions from age 55 (rising to 57 in 2028), but if you can afford to wait, there are advantages in doing so.
Money in a pension is protected from UK income and capital gains tax. It’s also usually protected from creditors and inheritance tax. If left untouched there’s the potential for continued tax-free investment growth, there’s tax relief on contributions up to age 75 (even if you’ve stopped working – limits apply), and a serious advantage for your loved ones after you’re gone.
You can normally take up to 25% of your pension tax-free. The rest is taxed as income. This is another reason why you might look to other sources of income first, to help fund your retirement.
Before you access your tax-free cash, you should consider how much you really need. It can be tempting to just take the 25% in one go. If you can afford to do so, you can opt to take your tax-free cash allowance in stages. You can do this by moving portions of your pension into drawdown, taking up to 25% of that amount, and leaving the rest invested. Just make sure you’re happy with the risk of investing.
GUIDE TO TAKING MONEY FROM YOUR PENSION
When you need to start drawing an income above your tax-free cash entitlement, you'll start paying tax on the income you receive that’s above your personal allowance. Those who have a standard personal allowance of £12,570, will normally start paying basic-rate tax (20%) when their annual income exceeds that amount and higher-rate tax when their income exceeds £50,270.
Different tax rates and bands apply to Scottish taxpayers.
Get advice on your retirement plans
Retirement is a time when you may feel unsure about what to do with your money and need help to make decisions.
Our financial advisers can work with you to plan your retirement income strategy. They can also make sure your investments match your goals and give you advice on when and how to take your pension.
