Approaching retirement age allows you to start drawing your regular retirement income from your pension savings, but could you and your beneficiaries be better off by using your ISA savings first?
In particular, wealthy pensioners could benefit from drawing their retirement income from their ISA first, as it could minimise their inheritance tax liability.
Pension or ISA for your Income?
On April 6, new death benefit rules were introduced, allowing the full value of a pension to be passed on to beneficiaries tax-free if the pensioner holder dies before 75 years of age; should the pension holder die older than 75 years of age, the beneficiary would simply pay tax on the income taken from the fund.
Pensioners are typically held outside of your estate, so using your ISA savings as an income in retirement will allow your pension savings to remain invested for growth (up to the current lifetime limit of £1.25 million), benefitting both you if you need to access it later in life, and your beneficiaries for when you have gone: sitting outside of your estate and growing free of IHT.
ISAs and pensions continue to be taxed differently upon death, as an ISA is subject to IHT if the beneficiary is anybody but your spouse. Drawing a retirement income from an ISA also means it will be free of income tax, unlike drawing a pension income.
Currently only a small number of people are affected by IHT in the UK, as the personal allowance for the nil-rate band is worth £325,000; £650,000 if combined with a spouse.
David Cameron is looking to alleviate the tax paid on properties passed on to beneficiaries; the personal allowance may soon include an additional relief of £175,000 each on the deceased’s main property.
Again, combined with a spouse this means a property of up to £1million can be passed on free of IHT; a move that is designed to assist those in London and the South East who have seen property prices surge more than most.
Careful management from an independent financial advisor could see overspills of this investment falling within your pension allowance, though it must be careful not to exceed the lifetime allowance which actually reduces to £1million from next April.
The process of giving away financial assets to friends and family, known as ‘gifting’, has often been one of more popular ways of trying to alleviate a hefty IHT bill. Annually you can give away £3,000 that won’t be subjected to any form of IHT.
Gifting means that the transaction must take place in the short term, as you can give away additional assets and cash, but you must live for 7 years after the gifting date for the gift to be exempt from IHT. This is known as a ‘potentially exempt transfer’.
Pensions in drawdown are currently held in lower-risk investments, while ISAs tend to hold more risk while being aimed at long-term capital growth. As the death benefits change, and more and more people begin to draw their retirement income from their ISA before their pension, this situation could reverse.
By taking more risk with your pension over a longer period, it could generate you greater returns as it remains invested. You’ll also feel more cautious in your approach to risk within your ISA investments, as you’ll rely it on for your general income.