With new retirement rules coming into place, people will now have more control over how they spend their pension. While this is great news, it also means that you may want to reevaluate how you spend your money, to maximise your income.
Financial experts are now recommending a different order of pension spending. They advise hoarding your pension pot and spending other available cash and investments first. This is to help minimise the amount of money lost to inheritance tax.
This method is becoming increasingly appealing to retirees wanting to minimise their annual income tax or use their capital gains tax allowance efficiently. They may benefit from spending any assets held outside a pension first.
While circumstances vary, and it is always best to check with a professional about your own situation first, this is useful general guidance on how to make the most of your savings.
How does spending your pension last benefit your finances?
The pension freedom reforms in 2015 altered the way in which many view pensions. More people than ever are choosing to keep their pension invested in financial markets in old age rather than receive a guaranteed income from a final salary work scheme or an annuity.
Through putting your pension savings into an income drawdown scheme at retirement, any investment growth will benefit your portfolio. As well as this, you will not be taxed unless, or until, you withdraw money as income. You can take 25 per cent tax-free from your pension, but after this, income tax is levied on withdrawals.
It’s also worth noting that keeping your money in a pension pot can also positively affect any inheritance you leave. It can help to cut down on the amount of inheritance tax that your loved ones will have to pay. This will happen if your estate tops the basic or new home allowance thresholds.
Beneficiaries will either pay no tax on what is left over in a drawdown scheme if the owner dies before they are 75 years old, or their normal income tax rate if the benefactor is aged 75 or over.
So, you may want to consider using spending other assets outside a pension if you wish to bequeath as much as possible. There will be full inheritance tax to pay if it is taken from a drawdown scheme.
What is the best order for spending assets during retirement?
While the order may change on a personal level, this is a helpful guide to the most beneficial order.
- Investments held outside ISAs or other tax-efficient wrappers, such as shares, bonds, buy-to-let properties and funds. These could be subject to capital gains tax or inheritance tax. Through tapping these gradually, you can use capital gains tax allowances over time.
- Investment and cash ISAs, except for those held in an AIM portfolio that qualifies for business relief.
- Homes, if they push your estate above £2 million. Through downsizing and spending or gifting the money, you can cut your inheritance tax bill.
- Investments with BPR status. These are shielded from inheritance tax if you have held them for at least two years by the time you die.
- Pension pots invested in income drawdown schemes. These remain a tax-efficient wrapper and have inheritance tax benefits.