Saving for a jigsaw

In April last year, the pension freedoms introduced flexibility around pension income withdrawal. This was seen as a massive positive within the retirement industry. However in April 2016, the lifetime allowance will drop to £1m.

In addition, the annual allowance has been reduced to £40,000 for those who earn under £150,000. Those earning over this amount lose £1 of annual allowance for every £2 earned over £150,000 to a maximum reduction of £30,000, which will mean anyone earning over £210,000 will have an annual pension allowance of £10,000. If you believe the rumours, George Osborne may limit higher rate tax relief on pension contributions in the March budget.

Because of these changes, a pension is now just another tax wrapper like ISAs, offshore bonds, an open-ended investment company (OEICs), venture capital trusts (VCT) and enterprise investment schemes (EIS). To reap the most benefit in retirement, investors need to utilise all of the available tax wrappers. This is especially true for high earners due to the lowering of the life time allowance, the reduced annual allowance and potentially tax relief.

So, what is available to savers and how will investing in multiple tax wrappers help in retirement?

Pensions

Pensions receive tax relief on the contributions and then the money also grows tax free. However, pension income is taxed as earned income. At this point, it would make sense to use the income from your pension to maximise use of the personal allowance.

Offshore and onshore bonds

Offshore investment bonds impose no tax on the income and gains of the underlying funds (known as gross roll up). When an offshore investment bond is surrendered, an individual can be charged income tax at their highest rate. However, offshore bond gains are treated as savings income, and are therefore taxed after earned income but before dividends as opposed to onshore bond gains.

Since 6 April 2015, the starting rate for the savings limit is the individual's personal allowances, plus the starting rate band of £5,000. Assuming someone withdraws £10,600 (2015/16 personal allowance) from their pension, and then lifts £5,000 of the gains from their offshore investment bond, they would enjoy another £5,000 income tax free. They could also withdraw the allowed 5 per cent tax deferred from the bond for further tax efficient income.

ISAs

ISAs are an extremely flexible and widely used option, as they are free from income and capital gains tax. The ISA wrapper allows the funds within them to grow tax free and allows the investor to take tax free withdrawals, which will provide further tax free income in retirement.

Investing in funds

OEICs and Unit Trusts are generally taxed on capital gains. Each individual has a capital gains allowance of £11,100 (tax year 2015/16). This allows for the encashment of such funds up to the gain of £11,100 to further provide tax free 'income'. These funds may also be held within the ISA wrapper.

VCT and EIS

For individuals restricted by either the new lifetime allowance or the loss of some of their annual allowance due to their higher earnings, they will need to consider VCTs or EISs for tax relief.

VCTs are highly tax efficient UK closed-end collective investment scheme, designed to provide private equity capital for small expanding companies and capital gains for investors. It provides 30 per cent income tax relief, no liability to the higher rate on dividends and no tax on capital gains, providing the investment is held for at least five years. £200,000 is the maximum permitted investment.

An EIS is designed to encourage investment into small unquoted companies that carry on a qualifying trade. It provides 30 per cent income tax relief up to £1m, which can be carried back to the previous tax year. Not only can it provide tax free growth, it also allows full IHT relief, provided the investment is held for at least two years at the time of death.

Capital gains tax from a previous investment can be deferred when investing the gain into an EIS and it also provides tax relief from investment losses. This type of investment is deemed to be higher risk and is not suitable for everyone.

Investors need to consider all available tax-free wrappers as the opportunities to save for retirement become more complex and less generous. These wrappers will benefit them now (tax relief) while the money is growing (tax free growth) and in retirement (tax free income). They all play their part in the tax-free saving jigsaw. 

Peter Savage is a chartered financial planner at Fairstone Financial Management