The thought of being hit with hefty taxes when you enter you reach retirement is a bitter pill to swallow. But there are ways to legally reduce taxes in your golden years. You can actually generate a six figure tax free income if you start planning early and make use of the tax wrappers and allowances that are available.
Here are a 5 steps to consider if you want to have a tax-free retirement.
Step 1: Personal Allowance
The first allowance to make use of is the Personal Allowance. Anyone earning less than £100,000 a year can earn £11,500 tax-free. In essence this means that the first £11,500 you receive from your pension is tax free!
In order to make full use of the personal allowance, make sure you aren’t just paying money into one partner’s pension. Even if your spouse is not working, they can save £2,880 a year into a personal pension and enjoy 20% tax relief, taking the amount up to £3,600 a year. This way, both you and your spouse will be able to have an income of up to £23,000 tax free.
Step 2: Dividend Allowance
The dividend allowance lets you receive £5,000 in dividends each year without paying any tax (soon to be reduced to £2,000). Both partners can use the allowance, which can be helpful if you are a business owner. You could give some of your shares to your spouse and, because you’re married, you won’t crystallise any capital gain.
Step 3: Savings Allowance
The Savings allowance enables basic rate taxpayers to receive £1,000 interest from savings accounts tax-free each year; for higher rate taxpayers the figure is £500.
This allowance can be useful for cash savings. Cash savings are essential for a rainy day fund or to avoid the fluctuation of the markets. I’ve recently written about the psychological benefice of holding cash and that is well worth a read.
By just combining the personal allowance, dividend allowance and savings allowance, a person is able to have a tax-free income of £17,000 in retirement.
Step 4: Capital Gains Allowance
The Capital Gains allowance allows an individuals to realise £11,100 in capital gains each year without having to pay tax.
Essentially, a person in retirement can sell investments and use that money to boost their income without paying tax if the amount they make on the investment is less than £11,100 each year,’ he says.
Step 5: Tax Free Accounts
By saving in a tax-free account in your working life, you are able to give yourself a lower tax footprint in retirement. The two best tax free accounts are Pensions and Individual Saving Accounts (ISA)
Pensions are the most popular savings account for those wanting to sock away money for their retirement. Pensions allow an individual to receive tax relief at their highest marginal rate on everything they save. So a basic rate taxpayer will get relief of 20%, high rate payers get a relief of 40% and additional rate payers get a relief of 45%. Have a read of this article to see how pension payments and reliefs work.
The two main catches with a pension is that you are only able to withdraw money from it once you hit 55 years of age and you are only able to take 25% of the fund tax-free; you need to pay marginal rate of tax on the rest of the money you withdraw (after your personal allowance).
Individual Savings Accounts, or ISAs, are another effective way to build up retirement income. Although you pay into an ISA using taxed income, there is no income tax or capital gains tax levied when you withdraw money. When saving via an ISA, it is best to start young – read my article on compounding to find out why. With compounding, I believe it is easy for anyone to become an ISA millionaire. And the best part is you are able to withdraw your millions completely tax free!