When former UK Chancellor of the Exchequer George Osborne unlocked the door to pensions in his 2014 Budget, many were worried he had thrown away the key. Private pensions, previously confined to buying an annuity with capital locked away in an insurer, were from April 2015 suddenly available as cash.
The Treasury had estimated that pension withdrawals would generate an extra £900 million of income tax over the first two years. The real figure turned out to be £2.6 billion, as retirees rushed to cash in.
According to Stan Russell, retirement income expert at Prudential, many 'are withdrawing money to sort out their finances for retirement, with many paying off mortgages and debts, as well as helping out family and enjoying themselves.
'However, it is also clear that without careful planning, the taxman could benefit from people making the most of the newly acquired access to their pension funds.'
For 40% or 45% taxpayers, a £10,000 contribution into your retirement fund which only costs you £5,500 or £6,000 is a mighty incentive to use a pension. It means more going into the pot, and reaping the benefits of compounding. You can take 25% tax free once you are age 55 (though that will rise to 57 by 2028), and there is no temptation to hack into the fund along the way.
But even though chancellors for the past 20 years have resisted the call to cut this valuable tax relief, they have in recent years ratcheted up the restrictions on the overall tax benefit. The annual contribution limit has been cut to £40,000, tapering down to just £10,000 for those earning between £150,000 and £210,000. The lifetime allowance has been slashed to £1 million - though a £30,000 rise was announced in the November Budget - above which a 55% tax rate bites.
The annual limit has also been slashed to just £4,000 a year for those who liberate the pension, but are minded to recycle cash back into it.
For those who transfer the pension into drawdown, income tax is the key issue. Let’s say you have a typical old workplace defined benefit pension paying out £8000 a year, and you are entitled to full state pension paying £7500. You start paying basic rate tax above the personal allowance of £11,500, and have headroom of around £30,000 in pension drawdown income, before the 40% tax band kicks in.
But if you have also had the foresight to build a retirement fund out of already taxed income in the shape of an ISA, you have an attractive alternative source of income, tax-free for both income and capital gains, and not affecting your tax band. Only £2000 of dividend income is now tax-free outside an ISA.
The annual contribution limit for ISAs has more than doubled in recent years, to stand at £20,000.
ISAs have the benefit of being freely accessible along the way, and money withdrawn can be replaced within a single tax year, without counting as new contributions. So as long as you start early enough, can put enough aside, and adopt a savings discipline, your ISA can serve as a holiday or education fund, as well as a retirement pot.
Steven Cameron, from pension specialist Aegon says: 'It’s very hard to envisage any situation where all of an individual’s savings needs can be met through a single savings vehicle. Most people should be saving through a combination of pensions and various forms of ISA.'
Some of the most prized aspects of the new pension freedoms actually help to make an even stronger case for parallel ISAs that will fund retirement income.
Penal tax rates for passing on a pension fund when you die have been dropped. Instead, the recipient will now pay only their marginal tax rate, if the fund is in drawdown. You have the added reassurance of knowing that should you fail to reach your 75th birthday, there will be no tax bill at all. By contrast, investments including ISAs which are left behind on death will inevitably form part of your estate. That means 40% inheritance tax, whoever is the recipient.
So for those fortunate enough not to have to rely too much, or at all, on their liberated pension for income, and whose estate is likely to come into the IHT net, there is a powerful incentive to prioritise ISAs for their retirement income needs.
Jason Hollands, managing director of Tilney Bestinvest, the independent financial advisers, says: 'Investors with a range of other assets that will ultimately form part of their estate for tax purposes on death should prioritise exhausting these to fund their retirement, touching the pension last of all.'
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You should always take independent tax and retirement planning advice.