How to reduce the tax on your retirement income

Planning for your retirement can be an exciting and rewarding process, and pensions are an excellent way to grow your wealth. However, if you’re earning in excess of £100,000, there may be some financial challenges to overcome, and complex tax rules to navigate.

Reducing your tax burden and structuring your wealth in a diverse way, is a key part of retirement and financial planning. In fact, diversifying your tax wrappers is arguably just as important as diversifying your investments.

In this article, we’ll explore how you can do just that, and make the most of their various uses and benefits.

The four-box principle

As the name suggests, the expert theory known as the ‘four-box principle’ focuses on four core tax wrappers. Used in the most effective way, these can help to reduce the tax you need to pay in retirement.

These tax wrappers are:

• Self-Invested Personal Pension (SIPP)
• Individual Savings Account (ISA)
• General Investment Account (GIA)
• Offshore Bond

They can be applied differently depending on your situation, and whether you’re accumulating wealth or withdrawing your assets. In addition, if all four are used in the right combination, it can have a significant impact on your wealth.

Self-Invested Personal Pension

As previously mentioned, pensions are an incredible way to build wealth. This is mainly because pension contributions are gross of all tax, and free of capital gains tax. The growth of your fund is also free of tax.

Then, when it comes to the withdrawal, you can usually take up to 25% of your savings completely tax free. The remainder is taxed at your marginal income tax rate.

Individual Savings Account

Another tax-efficient way to invest is through an ISA. Your contributions are net of income tax and national insurance, but the growth is within a tax-free environment. When it’s time to withdraw from your account, you can access your money without any tax implications.

General Investment Account

GIAs are a fully taxable environment, meaning any income, gains and dividends are liable for income tax and capital gains tax (CGT), at respective marginal rates. However, you can make use of your CGT allowance to access a significant amount of money tax-free.

For the current tax year, the CGT allowance is £12,300. Any gains over this amount are taxed at the marginal CGT rate.

Offshore Bond

A bond essentially defers tax. Your contributions are net of income tax and national insurance, but the bond itself is a tax-free environment. Although, it’s worth noting that certain geographies may apply withholding tax.

You can access 5% of your initial investment every year without an immediate tax charge. Any gains withdrawn from a bond are taxed as income in line with the marginal rate.

Tax wrappers in practice

In order to understand the four-box principle further, let’s look at an example of a couple with £2,000,000 invested. Using these tax wrappers in the right way, they can withdraw around £90,000 a year in retirement, accessing their money completely free of tax.

They have structured their combined assets as follows:

• SIPP — £750,000
• ISA — £500,000
• GIA — £500,000
• Offshore Bond — £250,000

The couple can take 25% of their pension without paying tax, and further withdrawals are taxed as income, in line with the couple’s marginal rate. However, they can both use their tax-free personal allowance of £12,570 each to withdraw a total of £25,140 from their pensions — completely tax-free.

As previously mentioned, all withdrawals from their ISAs can be taken without any tax implications. Next, the couple can access £24,600 from their GIAs, using their joint CGT allowance, and therefore without paying tax.

Finally, they can withdraw 5% from their bond, which is equivalent to £12,500. Again, there is no tax to pay on this amount. This brings the total to £90,000 a year, and the couple’s requirements can be fulfilled, tax-free.

—

If you’re investing for retirement, then it’s important to consider the ‘four-box principle’. To see the best results, it’s worth consulting with a financial adviser, to ensure your plan is as tax-efficient as possible.

Disclaimer: Information is correct to the best of our understanding as at the date of publication. Nothing within this content is intended as, or can be relied upon, as financial advice. Capital is at risk. You may get back less than you invested.