Employment earnings are generally taxed through the PAYE (Pay as You Earn) taxation system with Income Tax rates at 20% (basic rate); 40% (higher rate) and 45% (additional rate). Scotland has five Income Tax bands – with rates at 19%, 20%, 21%, 41% and 46%.
When we build an income strategy, we can control our tax rate by using the allowances available to generate income from a portfolio in the most tax efficient way.
The foundations for income generation
To maximise tax efficiency, it is best to have a diverse portfolio using different tax allowances, for example Individual Savings Accounts (ISAs) and pensions which grow free of Income Tax and Capital Gains Tax. Pensions provide tax relief on contributions and a tax free lump sum on retirement as well as a taxable income. Although contributions to ISAs do not receive tax relief, withdrawals are completely free from Income Tax and Capital Gains Tax. You may also have investments in Unit Trusts, Open Ended Investment Companies (OEICs), Investment Bonds or individual shares, which can be managed tax efficiently.
How can you get a low tax rate on your income?
There are many ways for you to generate income in a tax efficient way and the following can be particularly helpful when providing income in retirement:
• Personal income tax allowance
• Dividend allowance
• Tax deferred withdrawals from Investment Bonds
• Tax free lump sum entitlement from your pension fund
For example, if Margaret was to earn income of £80,000 in this tax year (2019/20) she would be subject to Income Tax (in England and Wales) as follows:
Amount | Tax Rate | Tax Payable | |
Personal allowance | £12,500 | 0% | £0 |
Basic rate band | £37,500 | 20% | £7,500 |
Higher rate band | £30,000 | 40% | £12,000 |
Total | £80,000 | 24.375% | £19,500 |
Please note that Scotland has five Income Tax bands – with rates at 19%, 20%, 21%, 41% and 46%, so the tax calculations would differ and total tax payable would be £21,344 with a tax rate of 26.68%.
So Margaret receives just over £60,000 net of Income Tax.
In retirement Margaret wishes to maintain the same level of income from her investments. Through careful planning she could potentially pay no tax by making withdrawals from her portfolio as follows:
Income source | Amount | Allowance used |
Income from pension fund | £12,500 | Using Income Tax Personal allowance |
Tax free cash from pension fund | £20,000 | Usualy 25% of the pension fund can be tax free and this can be taken in instalments |
ISA withdrawal | £25,000 | ISA withdrawals are free of Income Tax and Capital Gains Tax |
OEIC/Unit Trust withdrawal | £12,500 (Gain of £5,000) | Gain within annual tax free Capital Gains Tax allowance |
Bond withdrawal | £10,000 | Annual tax deferred withdrawal of up to 5% of original investment – (Margaret invested £200,000) |
Dividends from shares | £2,000 | Annual Dividend allowance |
Total | £80,000 |
This outcome is very attractive to Margaret as she can either reduce the withdrawals from her portfolio to the income she needs (i.e. £60,500) or she can enjoy higher levels of income as no tax is payable.
This example demonstrates the potential of generating tax free withdrawals from your investments but there are other considerations for building sustainable sources of income.
Building a long term income strategy
How much you can take from each source of income depends on the structure of your portfolio.
There are also other personal considerations which should be reflected in your income strategy. For example, your pension fund is generally exempt from Inheritance Tax, so it may be preferable to take more income from other investments rather than your pension, so that it preserves more of your wealth for your beneficiaries when your die.
You should also remember that you and your spouse/partner each have individual allowances which can be used together to maximise tax efficiency.
How can Origen help?
We have a range of cashflow modelling and planning tools which can be used to identify the most tax efficient way to provide the income you need in retirement. With careful planning and through our advice, you can look forward to maximising the tax efficiency of your investments in retirement.
Ask your Origen adviser to review your portfolio and identify how you can use the tax allowances available.
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