Heads up: This is a very numerical post. This is because I wanted to show you the maths behind why I ignore taxes in my retirement calculations. Please go through the examples slowly. This will help to make sure you understand them in order to make the most benefit of this post. I wouldn’t want a lazy person to read a section twice.
Not in the mood for numbers? scroll down to the summary.
In addition, I am writing this post in February 2021 so I’m using the 2020/1 tax rates. Future tax rates can, of course, change- they can increase or decrease. As I don’t have a crystal ball, I will use current rates (although 2021/2 rate are available but not significantly different) in my calculations.
A big part of planning for your retirement is knowing how much money you expect to have and when. Knowing the amount of taxes in retirement significantly affects the “how much”.
Some money is almost immediately available (liquid) like ISAs, savings, and cash. Some money is “locked” until you reach age 55 or older (depending on your age and how the law changes).
The main two “locked” amounts are LISAs and personal pensions.
The first one, LISA, is the Lifetime ISA. I hope to dedicate a separate post in the future for these, meanwhile, here’s the government’s explanation. The second one is your personal pension, which we’ll dive into a bit deeper. Having this money “locked up” means that it could be decades (hopefully) from the moment you retire until you can access your pension money.
Tax free amounts
Your cash, Cash ISAs, and S&S (stocks and shares) ISAs are completely tax-free. This means that you can withdraw them without incurring any tax. You may, however, incur some withdrawal fees, depending on which platform you use for managing your ISAs. We use Vanguard who don’t have any withdrawal fees. It’s easy to see why you can ignore taxes in this case.
LISAs are only available for withdrawal at age 60. There are two exceptions to this- if you’re buying your first home or are terminally ill, god forbid. This means that, although it’s less liquid than the previous amounts mentioned, it will also be withdrawn tax-free. Again- no calculation needed and I can ignore taxes.
It is important to mention you can take your LISA out before age 60 without buying your first home or being terminally ill. However, you will incur a 25% “fine”. This means that if you have £20,000 in a LISA and you want to withdraw it now, you will only be able to take out £15,000 (£20,000 * (1-25%)). Therefore, you should really be using this only as a last resort.
Personal pensions are a bit different, they are not completely tax-free and they are also not liquid.
This means some financial modelling comes into play and assumptions need to be made. How much will you have and when?
The “When” is the easier part to calculate, just look at the law now. For us, it’s currently 55 and expected to grow to 57 by 2028 (details here). In my model, I assumed I will be able to access this money when I am 60. This is because I expect future increases.
The “How much” is a bit trickier. Not only do you need to assume contributions and investments yield, you also need to assume a tax rate.
Under current rules, you can withdraw 25% of your personal savings tax-free. That’s why a lot of people take it out as a lump sum, which I completely understand.
“Ok, this one’s easy- we can ignore taxes for 25% as there isn’t any. What about the other 75%?“
Ah, now we get to the interesting stuff.
Everything about withdrawing your pension can be found here (yes, another link to a GOV.UK website) but I’ll try to simplify it.
The main concept is that the other 75% will be taxed as normal income from an income tax perspective. There is no national insurance on pension withdrawals.
“So if it will be taxed as normal income, why do you ignore taxes?”
Great question (*patting myself on the back*)
Lazy FI person has been saving and investing since a young age. He retired at 50, is now 60 and can withdraw his personal pension and LISA.
He and his partner have annual household expenses of £48,000 a year (£4,000 per month). This is more than enough for them as they have a paid-off home (no mortgage). With a paid-off home and £4,000 (£2,000 each) of monthly expenses- they are living their dream life, which they achieved by working hard, saving and investing. Let’s analyse his situation and how he will cover his part of the expenses (£2,000 a month, half of the household expenses).
– £24,000 in cash
– £250,000 in ISAs
– £50,000 in LISA’s
– £300,000 in a personal pension
Using the 4% rule (or 300 rule) he needs 300 times his monthly expenses or 25 times his annual expenses, so £600,000. However, this needs to be AFTER TAX.
If we sum his net worth (ignoring his main residence) we see it is £624,000. However, if he will withdraw the £300,000 personal he will incur a HUGE tax bill which will bring him way below the £600,000, so what can he do?
- Take out 25% as a tax-free lumpsum, for him it will be £75,000 (£300,000*25%). This will bring his liquid net worth to £399,000 (£24,000 + £250,000 + £50,000 + £75,000).
- As the remaining £225,000 (£300,000-£75,000) is now treated as income, he can maximise his personal allowance, which is £12,500 for the 2020/1 tax year ending on April 5th 2021. This means that the first £12,500 each year will come from the personal pension (tax-free) and the remaining £11,500 (£24,000-£12,500) will come from the liquid £399,000.
While £12,500 is more than 4% of £225,000 (5.56% to be exact), the remaining £11,500 is less than 4% of the £399,000 (2.89%). In total, he is withdrawing £24,000 out of a £624,000 pot which represents 3.85%. I would expect the tax-free amounts to increase while the personal pension amount will decrease until only the tax-free amount is left.
Withdrawing 25% as a lump sum and then only the personal allowance means that Lazy FI person will incur no tax on his savings withdrawals. This is why I ignore taxes in my retirement plan even though I have a personal pension.
“But what if you plan to withdraw from your personal pension more than the annual allowance each year“
First of all, I hope that we, personally, will not need more as we will have enough income from other sources but let’s look at an alternative approach with an example where you fund your lifestyle completely from your personal pension.
Lazy FI person is now in a parallel universe where he is 60, does not enjoy the economies of scale that come from being a part of a couple (I know, I’m so romantic), he got to an age where he can withdraw his personal pension money.
He has £36,000 annual expenses (£3,000 a month).
He also has £1,000,000 in his personal pension and no other assets besides his paid-off home.
First of all, he can withdraw 25% (£250,000) tax-free. Using the 4% rule, this amount will provide him £10,000 a year (£250,000 * 4%). So he now has £10,000 a year after-tax. In addition, he has a taxable amount of £750,000 left in his personal pension. Again, using the 4% rule, this means £30,000 (£750,000 * 4%) a year BEFORE TAX.
Based on the 2020/1 tax rates, the gross £30,000 will become a net (after-tax) £26,500*. Now he has £36,500 a year to (more than) cover his expenses:£10,000 from the tax-free 25% and £26,500 from the taxable 75%.
Let’s calculate the effective tax rate:
We have 25% that can be withdrawn with no tax so 0%.
In addition, we have 75% that incurred tax, but at what rate?
£30,000 turned to £26,500, that means £3,500 is tax (£30,000-£26,500).
£3,500/£30,000= 11.67%. That’s the tax rate on the taxable part.
To get to the effective tax rate we need to add the weighting:
25% * 0% + 75% * 11.67% = 8.75%.
Please note that in this scenario, Lazy FI person actually withdraws £500 more than he needs a year (£36,500 – £36,000). If, however, he did not have enough, the difference could be covered by many different sources:
- State pension
- Other investments- In this scenario, Lazy FI person doesn’t have any but it shows how important it is to invest in more than just your personal pension
- Renting out a room in his home
- Paid work- although Lazy FI person has retired, he can maybe get paid to do what he loves. I, personally, want to focus on teaching and tutoring once I retire from my current career, this will come with an income.
- Withdrawing more than 4%- this is a bit risky as the higher percentage you choose to withdraw, the risk of running out of money becomes higher as well.
Please also notice that most of the income sources above will be taxable, so if you have such income sources or plan to have them, your effective tax rate will be a bit higher. However, if you need more money to pay for your expenses, just pay a bit more tax, it’s absolutely fine 🙂 There’s no point in not covering your expenses or withdrawing a non-sustainable percentage of your savings just to save some tax.
Should you put your money into ISAs instead of a pension?
I wish it was that straightforward. There are many considerations to take into account when deciding between ISAs and a pension.
From a liquidity point of view, ISAs are more liquid. However, you pay into your ISAs from your net (after-tax) salary, which means 100% of that money was taxed. With pensions, as we saw, only 75% will eventually be taxed.
In addition, if your marginal tax rate is 42% (if you earn between £50,000 a £100,000 a year) and plan to withdraw less in retirement, the benefit of a pension is even greater as you save 42% by paying into your pension from your gross salary and then paying a lot less (in our examples, between 0% and 8.75%) when you withdraw the money.
So while pensions are great from a tax perspective, they are very illiquid and are “locked” for years.
As there are many considerations (I only mentioned a few), I would recommend using a professional tax adviser to assess your own unique circumstances.
If you can (or plan to) cover your expenses by only withdrawing your personal allowance every year AFTER:
- Taking 25% of your personal pension as a lump sum
- Using your LISA and other ISAs
- Using any other source of income or assets
Then you can, as I do, assume a 0% tax rate on your pensions and basically ignore taxes in your retirement calculations. Simple, easy and perfect for lazy people.
If you intend to cover £3,000 a month just from your personal pension, you can assume 8.75%. Any amount between the personal allowance and the £36,500 (net) annual will result in a tax rate between 0% and 8.75%.
Of course, if you plan to cover more than £3,000 a month from your personal pension, assume a higher tax rate but this probably means you have more than £1,000,000 in your pension (great job!) and will probably want to look into the Lifetime allowance.
What do you do?
I know some of my readers are very good at financial modelling, please let me know in the comments if you include or ignore taxes in your calculations/models and why.
*How I got to £26,500 from £30,000 using 2020/1 tax rates:
£12,500 is tax free (personal allowance) and £17,500 taxed at 20%. £17,500*20%= £3,500
There is no national insurance on pension withdrawals. Thank you Carl for pointing this out in the comments section!
Total tax: £3,500 + £0 = £3,500
Total net: £30,000 – £3.500 = £26,500