Last week's reader portfolio mentioned the potential benefits of transferring pension drawdown money into individual savings accounts (Isas) to introduce more flexibility over access to tax-free cash and to optimise income. We also described how someone with £300,000 upwards in a drawdown account could withdraw additional income over that needed at basic rate tax (but not enough to pay higher-rate tax) and then invest it into an Isa.
However, many readers say they are confused about how income can be improved using this strategy and have asked for further clarification.
The accelerated withdrawals from a pension into an Isa will have no immediate impact on dividend income - it's a zero sum gain. This runs contrary to the explanation given in last week's Tax Tip (IC 20 June 2014) - for which we apologise.
One IC reader rightly says: "If a higher-rate taxpayer suffers 40 per cent tax on the withdrawal of the capital from the Sipp, then that would eliminate the gain on income received from the Isa investment." A basic-rate taxpayer would also find this is tax neutral.
In fact, the potential gain is from the total investment income over a period of several years. James Baxter of Tideway Investment, who advocates this type of tax planning for wealthy investors, says: "Some IC readers are suggesting that accelerated withdrawals from pension to Isa will have no impact. This would be true if drawdown accountholders could ensure 20 per cent tax on all future withdrawals. But for those getting older with larger funds above £300,000 this won't be the case.
"Imagine how it will feel to have to sit there at say 80 with £500,000 in your pension drawdown account and be weighing up paying 55 per cent tax on death or paying 45 per cent income tax to take out £150,000 or more. Note the worst withdrawal level will be around £90,000 as if this combined with other income takes you over £100,000 taxable you also lose your nil rate tax band. This can be a punitive £4,000 extra tax for taking £1 too much income at this level."
He has modelled for IC how the overall investment income can be improved by transfer to an Isa, using the example of a 67-year-old with a pension drawdown account of £500,000, who wants to take annual income of £16,000 a year linked to inflation. The investor's goal is to exhaust the pension fund over 18 years to avoid the 55 per cent tax charge on residual pension funds.
The investor has state pension and income that utilises his nil rate tax band. He then draws £16,000 net of basic rate tax from the drawdown account. From 80 onwards, he increases his withdrawals to fully exhaust the account at 85. The projection uses a 2 per cent real rate of return - equivalent to a 5-6 per cent gross return today before inflation and fees.
Alternatively, the investor could withdraw more income than he needs - say £24,000 net of basic rate tax and put the surplus £8,000 into an Isa. Mr Baxter calculates that by getting more of the withdrawals out at basic rate tax over the life of the investment and fewer at higher rate, over the 18 years he gets £13,228 more net income from the pension - £473,344 compared to £460,056.
By saving the surplus income into an Isa, this strategy compensates for the extra £28,000 tax paid up to age 80 by producing an overall gain to the investor of £36,983 over the 18 years. He can then take this as tax-free income. The withdrawals and outcome from the two scenarios are shown in the tables below.
Scenario 1: Exhausting pension drawdown account only
Real Investment Return: 2 per cent
Age | Pension drawdown account | Gross Withdrawals | Net Income | Spending Need | Surplus income | Balance outside pension |
67 | 500,000 | 20,000 | 16,000 | 16,000 | ||
68 | 489,600 | 20,000 | 16,000 | 16,000 | ||
69 | 478,992 | 20,000 | 16,000 | 16,000 | ||
70 | 468,172 | 20,000 | 16,000 | 16,000 | ||
71 | 457,135 | 20,000 | 16,000 | 16,000 | ||
72 | 445,878 | 20,000 | 16,000 | 16,000 | ||
73 | 434,396 | 20,000 | 16,000 | 16,000 | ||
74 | 422,683 | 20,000 | 16,000 | 16,000 | ||
75 | 410,737 | 20,000 | 16,000 | 16,000 | ||
76 | 398,552 | 20,000 | 16,000 | 16,000 | ||
77 | 386,123 | 20,000 | 16,000 | 16,000 | ||
78 | 373,445 | 20,000 | 16,000 | 16,000 | ||
79 | 360,514 | 20,000 | 16,000 | 16,000 | ||
80 | 347,325 | 20,000 | 16,000 | 16,000 | ||
81 | 333,871 | 80,000 | 54,000 | 16,000 | 38,000 | 38,760 |
82 | 258,948 | 80,000 | 54,000 | 16,000 | 38,000 | 78,295 |
83 | 182,527 | 80,000 | 54,000 | 16,000 | 38,000 | 118,754 |
84 | 104,578 | 80,000 | 54,000 | 16,000 | 38,000 | 159,754 |
85 | 25,070 | 25,070 | 20,056 | 16,000 | 4,056 | £167,086 |
Total Net income taken: £460,056 | Total spending: £304,000 | Total surplus: £156,056 | Total balance outside pension: £167,086 |
Scenario 2: Taking surplus income from pension drawdown account and transferring to Isa
Real Investment Return: 2 per cent
Age | Pension drawdown account | Gross Withdrawals | Net Income | Spending Need | Surplus income | Isa balance |
67 | 500,000 | 30,000 | 24,000 | 16,000 | 8,000 | 8,160 |
68 | 479,400 | 30,000 | 24,000 | 16,000 | 8,000 | 16,483 |
69 | 458,388 | 30,000 | 24,000 | 16,000 | 8,000 | 24,973 |
70 | 436,956 | 30,000 | 24,000 | 16,000 | 8,000 | 33,632 |
71 | 415,095 | 30,000 | 24,000 | 16,000 | 8,000 | 42,465 |
72 | 392,797 | 30,000 | 24,000 | 16,000 | 8,000 | 51,474 |
73 | 370,053 | 30,000 | 24,000 | 16,000 | 8,000 | 60,664 |
74 | 346,864 | 30,000 | 24,000 | 16,000 | 8,000 | 70,037 |
75 | 323,191 | 30,000 | 24,000 | 16,000 | 8,000 | 79,598 |
76 | 299,055 | 30,000 | 24,000 | 16,000 | 8,000 | 89,350 |
77 | 274,436 | 30,000 | 24,000 | 16,000 | 8,000 | 99,297 |
78 | 249,324 | 30,000 | 24,000 | 16,000 | 8,000 | 109,443 |
79 | 223,711 | 30,000 | 24,000 | 16,000 | 8,000 | 119,792 |
80 | 197,585 | 30,000 | 24,000 | 16,000 | 8,000 | 130,347 |
81 | 170,937 | 30,000 | 24,000 | 16,000 | 8,000 | 141,114 |
82 | 143,756 | 30,000 | 24,000 | 16,000 | 8,000 | 152,097 |
83 | 116,031 | 30,000 | 24,000 | 16,000 | 8,000 | 163,298 |
84 | 87,751 | 30,000 | 24,000 | 16,000 | 8,000 | 174,724 |
85 | 58,906 | 58,906 | 41,344 | 16,000 | 169,344 | 204,069 |
Total net income taken: £473,344 | Total spending: £304,000 | Total surplus: £169,344 | Total balance in Isa: £204,069 | |||
Total income gain vs Scenario 1: £13,228 | ||||||
Gain net of tax vs Scenario 1: £36,984 |
Source: Tideway Investment
Mr Baxter concludes: "If there is a risk you will end up paying higher rates on pension withdrawals in later life, it will be worth optimising the basic rate band each and every tax year. The tax-free investment and tax-free withdrawals on Isas more than compensate for the extra tax paid in the earlier years."
This example assumes that all investment returns in the pension and Isa are equal.
However, Alan Higham, retirement director at Fidelity Worldwide Investment, points out: "There are consequences of taking the money out of the pension and then reinvesting it in an Isa and they are usually negative. There will be some time during the transfer when the funds aren't invested in the market. There may be some costs involved, too." Nevertheless, in general, Isas are cheaper to run than pension drawdown accounts.
An IC reader also says: "If you draw everything out of a pension you are relying on nobody tinkering with the Isa regime." However, to date the pensions regime has seen more tinkering than Isas to date.
Investors will have to weigh up any potential costs and transfer timing issues in their decisions. The type of tax planning that works best for you will depend on your whole portfolio, including assets held outside your pensions. If you are in any doubt, then take independent financial advice.