A group of British pounds notes in mousetraps on a slate background.Click on the link below to see more of my business images.

Are you one of the hundreds of thousands of people planning to retire across the UK this year? If so you will need to get your affairs in order to maximise your income in the next part of your life. Here are five tax traps to avoid in retirement.

1 Being hit by the pensions lifetime allowance

If you have a large pension pot of about £1m or more the pensions lifetime allowance (LTA) may come into play and could trigger excess tax charges when you come to take your pension benefits. If you have not done so already, Paul Ayres, national head of private client services at BDO, recommends looking at the protection options to lock in the higher LTA that existed before April 2016. You can only do this if you have not taken any pension benefits already — and it will prevent you from paying any more money in.

Jason Hollands, managing director at Tilney Investment Services, warns that anyone concerned about the LTA should think carefully before walking away from pension contributions altogether. “It is important to weigh up the potential loss of an employer’s contribution — even if these ultimately lead to a breach of the LTA and a 55 per cent tax charge on the excess. After all 45 per cent of something is better than 100 per cent of nothing,” he says.

2 Paying tax on pension contributions

The standard pension annual allowance — the tax-deductible amount an individual can set aside each year for a pension — remains at £40,000. However, from April 6 2016, a ‘tapered’ annual allowance has applied for those people with higher incomes. For example, the annual allowance is reduced by £1 for every £2 that a person’s total income exceeds £150,000, subject to a minimum tapered annual allowance of £10,000.

Note that your total income will not just include your salary — any bonus, employer pension contributions, dividends and even income from a buy-to-let property can count towards the total.

David Woodhouse, head of advice service, Chase de Vere, suggests people make use of “carry forward” rules to maximise contributions. These rules allow people to make pension contributions in excess of the annual allowance and still receive tax relief by carrying forward unused annual allowance from up to three previous tax years.

“When using carry forward it is important to note that somebody’s relevant UK earnings in the previous three tax years is not a consideration, but they do need to have been a member of a registered pension scheme at some point in the relevant tax years,” explains Mr Woodhouse.

3 Look beyond your pension for alternative investments

Pensions are not the only place to put your cash. There are many other tax-efficient options from Individual Savings Accounts (Isas) to life insurance bonds or even investments qualifying for Enterprise Investment Scheme (EIS) reliefs and Venture Capital Trusts (VCTs). All these have tax advantages and can be very helpful in building a tax-efficient investment portfolio outside of a pension wrapper.

VCTs and EIS’s both benefit from 30 per cent initial income tax relief plus tax free capital growth. VCTs also provide tax free dividends, while EISs allow capital gains tax deferral and can also provide inheritance tax savings.

Mr Woodhouse warns, however, that while the tax attractions of VCTs and EISs are undeniable, as they typically invest in small unquoted companies they should only be used by those who have a broad investment portfolio already in place and who understand and accept the high risks.

“Everyone should look to utilise their annual personal savings allowance, dividend allowance and capital gains tax exemption. You should do this each year while adding to pensions and Isas, so that an increasing amount of your money is held in these tax-efficient wrappers,” says Mr Woodhouse.

4 Minimise inheritance tax on your estate

Planning ahead is critical to avoid overpaying tax on your investments. For some investors with significant assets who expect their estates to be subject to inheritance tax, passing on their pension to the next generation could be an option.

If the pension is set up correctly to make use of recent rule changes, then if you die before age 75, pension assets can be received entirely tax free by whoever they are left to. If you die from 75 onwards the beneficiary will pay tax on these at their marginal rate as and when they draw on them. Mr Hollands adds that “inherited” pensions do not impact the pension allowances of those who receive them and could even be passed on untouched to yet another generation.

“Those in this situation might instead concentrate on utilising other potentially IHT-vulnerable assets to finance their retirement, perhaps drawing income from their Isas while crystallising capital on other assets such as shares or properties and running down their assets over time,” he says.

Isas cannot be passed on across the generations and the tax wrapper falls away on death. However, it is now possible for a surviving spouse to receive an extra “one off” Isa allowance on the death of their partner equivalent to the value of their spouse’s Isas, so that the tax benefits of assets their partner held in Isas is effectively retained by reinvesting.

5 Don’t keep surplus funds in your taxable estate

Giving away assets during your lifetime is a simple way to reduce the size of your estate for inheritance tax purposes. You can gift up to £3,000 a year IHT free, or £6,000 if you did not make a gift of this kind in the previous tax year. A married couple giving for the first time could, therefore, hand over £12,000 to their children in one year.

After that, the maximum for a couple is £6,000 each year. You can also give £250 to any number of people every year, but you cannot combine it with your annual £3,000 exemption. Parents can give £5,000 to each of their children as a wedding gift. Grandparents can give £2,500 and anyone else £1,000.

Rachael Griffin, tax and financial planning expert at Old Mutual Wealth says: “The ‘normal expenditure out of income’ exemption can be a valuable way for people to pass on wealth tax-free. However, to use this exemption you must ensure that you stay within certain rules, for instance it must not have a negative impact on your standard of living”.

Lucy Warwick-Ching is FT Money’s digital editor

The opinions in this column are intended for general information purposes only and should not be used as a substitute for professional advice. The Financial Times Ltd and the authors are not responsible for any direct or indirect result arising from any reliance placed on replies, including any loss, and exclude liability to the full extent.

Get alerts on Tax when a new story is published

Copyright The Financial Times Limited 2021. All rights reserved.
Reuse this content (opens in new window) CommentsJump to comments section