Tax efficient retirement strategies to maximise your income

The most common advice you hear is to diversify your investment portfolio. Strategically diversifying your tax wrappers and implementing smart retirement tax strategies can be just as impactful on your long term wealth as maintaining a well-diversified investment portfolio.[1]

Understanding retirement taxes

To achieve tax efficiency in retirement, it’s important to understand the different taxes that may apply to you. Different types of income and how you access your funds can affect your retirement and tax planning. Here’s a brief overview of the key taxes you should be aware of: 

Income tax

Income tax applies to various retirement income sources, including: 

• State Pension: The State Pension is considered taxable income, though it’s paid without deductions. It will be taxed at your marginal rate (20%, 40%, or 45%) depending on your total income.[2]
• Pension withdrawals: When you withdraw money from a pension (for example, defined contribution pensions, personal pensions), the amount is generally subject to income tax. If you take a lump sum, the first 25% is tax free, but the remaining 75% is taxed as income at your applicable rate.[1]
• Annuities: If you’ve purchased an annuity with the taxable portion of your pension pot, the income from the annuity is also taxable as income. 
• Other: Additional sources of funds in retirement, such as rental income, dividends, or interest from savings, may be subject to tax, depending on the type and tax treatment of each source. 

Tax free cash

When accessing your pension, you can usually take up to 25% of the total value as a tax free lump sum. This is capped at £268,275. The remaining 75% is taxable when withdrawn. Utilising this effectively is key to tax-efficient retirement withdrawal strategies, helping to access savings without incurring immediate tax burdens.[1]

Dividend tax

For those receiving income from investments like stocks or shares, dividend income is subject to tax. However, you are allowed an annual £500 tax free dividend allowance.[3]Dividend payments from investments held in ISAs remain tax-free 

Beyond your dividend allowance, dividend income is taxed at different rates based on your income tax band: 

• Basic rate: 8.75% 
• Higher rate: 33.75% 
• Additional rate: 39.35%

Savings interest tax

Interest from savings accounts, such as from bank or building society deposits, is subject to income tax, but you are entitled to an annual Personal Savings Allowance[4]: 

• Basic rate taxpayers: £1,000 
• Higher rate taxpayers: £500 
• Additional rate taxpayers: £0 

Any interest earned beyond the allowance is taxed according to your income tax rate.

Capital Gains Tax (CGT)

If you sell investments or assets, you may be liable for Capital Gains Tax on any gains above the annual exempt amount (currently £3,000).[5] Effective tax-efficient retirement planning can involve utilising CGT allowances to optimise withdrawals. The rates for CGT are: 

• 18% (basic rate taxpayers) 
• 24% (higher and additional rate taxpayers) 

However, there are exemptions, so it is worth speaking to a financial adviser for retirement tax planning.

Inheritance tax (IHT)

Though not directly affecting your retirement income, retirement tax planning advice often includes strategies for minimising inheritance tax. Generally, IHT applies to estates worth over £325,000. The standard IHT rate is 40% on the value above the threshold, though there are exemptions and reliefs that can reduce this burden.[6] The Residence Nil Rate Band (RNRB) may be available if certain criteria are met, potentially increasing the tax-free threshold when passing on a main residence to direct descendants.[7]

Tax efficient retirement planning: The four-box principle

There’s a method, known amongst financial experts, as ‘the four-box principle,’ which provides the secret to minimising the tax you pay on your retirement income. By utilising this strategy, it can be an effective way to achieve a tax efficient retirement. 

It’s called ‘the four-box principle’ as it focuses on four core tax wrappers. These tax wrappers include: 

• Your pension 
• An ISA 
• A general investment account (GIA) 
• An offshore bond 

What are the benefits of each tax wrapper?

Each tax wrapper plays a distinct role in retirement tax planning. These are applied differently depending on whether you are accumulating wealth or drawing on your assets: 

If made via salary sacrifice, pension contributions are gross of all tax (why they are incredible for building wealth) and free of CGT. It is important to note that withdrawals from a pension are taxed at your marginal income rate.[8]

Contributions to ISAs are net of income tax and National Insurance but, once the money is in the ISA wrapper, there will be no further tax to pay![9]

General investment accounts are a fully taxable environment (Income tax and CGT), but you can helpfully make use of your CGT allowance to access a significant amount of money tax free.[4]

Finally, an offshore bond essentially defers tax. You can access 5% of your initial investment every year with no immediate tax charge and they are free of CGT. Gains that are withdrawn from a bond will be taxed as income.[10]

How to get a tax free retirement income

Whilst utilising all of the tax efficient retirement strategies above may seem like an unnecessary amount of complexity, if you combine all four in the right way, it can have a liberating effect on your wealth. 

Let’s take a look at the four-box principal in practice using a couple with £2 million invested and the assumption they have all allowances fully available. The couple want to take around £85,000 a year in retirement. Using ‘the four-box principle’, believe it or not, they can access every penny of this completely free of tax:

They have been working with an adviser for some time and have structured their assets to help achieve a tax efficient retirement: 

As previously mentioned, (after 25% tax free cash is taken) withdrawals from a pension are taxed as income, in line with the couple’s marginal rate. Both have a personal allowance of £12,570, which means that £25,140 of income can be accessed from their pensions completely tax free. 

This level of available tax free income won’t change once their state pension commences; it simply means that up to £21,200.40 will be provided by the state with the balance being funded from their SIPPs.[11]

In addition, all withdrawals from their ISAs can be taken without any tax implications. Five per cent of their initial capital (£12,500) can also be accessed from their offshore bond each year without any immediate tax implications. 

They can make also use of their combined Capital Gains Tax allowances of £6,000 to access £20,000 of funds from their GIA without paying tax. Using this allowance can be confusing to people: assuming a 4% growth rate on their £500,000, the couple’s gain in year one will be £20,000. If they wanted to ‘fully crystallise’ this £20,000 gain, they would have to sell all £520,000 of their investments. The couple can crystallise £6,000 (30%) of this £20,000 gain tax free. This means the couple could sell up to £150,000 (30% of £500,000) of this pot without tax implications if they wished. However, as they want to sustain this income for the long term, they choose to only access £20,000 per annum.

As such, their income requirement can be fulfilled tax free by drawing income across their various pots:

By structuring their income this way, they achieve tax efficiency in retirement, ensuring they pay less tax overall on account withdrawals in retirement while maximising their savings. 

Final thoughts

£85,000 a year completely tax free… For those building wealth toward retirement, leveraging tax efficient retirement planning can ensure long term financial security. Implementing retirement strategies such as ‘the four-box principle’ can help you to access your money in the most tax efficient way possible. And, if it all feels a little bit too complicated, be sure to take some retirement tax advice…