I’ve talked a lot about my dislike of pensions: you must pay tax when you withdraw from it.
You work your whole life to build it up, only to pay tax on it in retirement, just like a job.
However, what if there was a way to not pay any tax when you withdraw from your pension:
In the UK, we get what is known as a ‘personal allowance’ which now is £12,570 per year.
This means that this is the amount of money we can earn without paying any income tax.
So long as we take out this amount or less from our pension per year, then we pay no tax.
However, as this is not enough to live off per year we can top up the difference with an ISA.
In this article, I talk a bit about pensions: their pros and cons, as well as personal allowance.
I also talk about Individual Savings Accounts (ISAs) and how to combine them with pensions.
Finally I talk about what this means for your retirement and where to go for more information.
Why I Dislike Pensions
If you’ve read any of my articles on retirement, then you know how much I dislike pensions.
Don’t get me wrong, workplace pensions are not all that bad, they do have some positives:
- If you’re employed, your employer must add to and even match your pension contributions.
- You get tax relief: in other words, you get the tax that you would have paid into your pension.
However, although they do have these good features, they also have some annoying aspects:
- You cannot take out your pension before 55 – unless you want to pay a massive fine in taxes.
- This age isn’t fixed, it increases to 57 in 2028, who knows what pension age will be in 20 years.
- However, the worst thing for me is taxes: you pay income tax on it when it’s time to withdraw.
For a long time I was thinking what’s the point of having a pension if I must pay 20% tax on it.
However, what if there was a way to not pay any taxes on your pension, in a totally legal way?
What is a Personal Allowance?
If you’ve read your payslip, you’ll have noticed that you pay income tax on your gross income.
This income tax is 20% if you earn below £50,270/year or 40% if you earn above £50,270/year.
However if for example you’re a lower rate earner you don’t pay 20% on the full gross income.
You only pay tax on the amount of money you earn that’s above your personal allowance.
In the UK, the current personal allowance amount per person is £12,570 (until the year 2028).
So what the heck does that mean? Let’s give an example by using an average UK salary:
Let’s say you have a salary of £30,000. On the first £12,570 of that, you don’t pay any tax.
That leaves £17,430, on which you would have to pay tax, in this case 20% i.e. £3,486 in taxes.
This means you would get a net income of £26,514 a year (not including other deductions).
Therefore, if your income is £12,750 a year or less, then you wouldn’t have to pay any tax.
This is where ISAs come in
I have long talked about Individual Savings Accounts or ISAs as great tools for early retirement.
Similar to pensions, ISAs are a type of tax efficient account that are used for market investing.
Let’s start with the negatives – there is no such thing as a perfect type of investing account:
- You can’t get your employer to contribute to this type of account: only to a ‘pension’ account.
- You don’t get any tax relief on this account: you invest in it like any type of savings account.
Now that those snags are out of the way, let’s talk about all the benefits of an ISA:
- You can withdraw money from it any age: you don’t have to wait until you are in your 50s.
- You don’t pay taxes on withdrawal: what you have in your account is all for you to withdraw.
So what’s the point of a pension? Your employer and government are giving you free money.
You’re getting free money for contributing to a pension, so you may as well reap the benefits.
ISA and Pension Combo
So now that we understand the pros/cons of a pension and ISA, let’s combine them together.
Let’s say after many years, you have a pension pot worth £200,000 – this is quite achievable.
Let’s also say that after many years, you have an ISA worth £500,000 – this is also reasonable.
One other thing to note is that with a pension, you can withdraw up to 25% of it tax free.
So that means with a £200,000 pension pot, you can withdraw £50,000 of it entirely tax free.
As we know, our current annual personal allowance is £12,570 a year, or £1,047.5 a month.
This is probably not enough for us to live off, we would probably need another £2,000/month.
This is where the ISA comes in: £24,000 from your ISA a year gives you an extra £2,000/month.
The key is to withdraw up to £12,570 from your pension each year and the rest from your ISA.
This is how you can have a yearly income of £36,570 or £3,047.5 a month completely tax free.
Pay No Tax on Your Income Either
It’s funny because this isn’t the kind of thing that people teach you about your finances.
For the longest time I didn’t think there was any point to pensions because of all the taxes.
What’s the point of receiving tax benefits if the government plans to take it all back anyway.
However, having learnt about personal allowances, it now makes sense to save into a pension.
This, as far as I’m aware, is the only way not pay any taxes if you withdraw to your allowance.
In fact, you can even apply this same principle of paying no income tax on your salary now.
If you have a yearly salary of up to £12,570, then you don’t have to pay any income tax.
However, as this is not enough to live off, you’d need to supplement it with your investments.
This is what some business owners do: pay themselves a small salary and the rest in dividends.
In the meantime, let’s focus on building our ISA so we are able to not pay taxes in retirement.
If you are interested to find out more about early retirement, check out: Quit Like a Millionaire.
In the book, the authors talk about how they were able to completely retire early in their 30s!
To find out more about ISAs and early retirement strategies, check out my investing articles.
I talk all about which platforms to use, which funds to invest in, and which accounts to have.
Are you on your way to early retirement? Do you have an ISA? Let me know in the comments!
