A perennial question I am asked by clients is how much income they should take from their investments and pensions. This is because we typically manage a significant amount of their wealth and, for many of them, their only source of guaranteed retirement income is their state pensions. So it is vitally important that they only take a level of income that is sustainable over the longer term. This is where our advice becomes invaluable.
Historically financial planners and academics have considered a safe withdrawal rate to be 4% a year. However, that was in an era when interest rates were much higher. These days I tend to recommend a withdrawal rate of 3% a year in most cases unless the clients are close to state/work retirement age and there is a shortage of a few years until their pensions start being paid. Under those circumstances, quite often clients will take a disproportionately high income of say 5% or more but then they reduce it by the amount of the newly paid pensions once they start being paid back at a level of no more than 3% and usually even less.
Of course, the time frame for sustainable income to last is also important. If you are terminally ill with only a short period to live and have no dependants then a long term sustainable income is less important than for say a recently retired married couple with life expectancy of say 20 years.
Another crucially important factor to consider is where to take your income from and in which order. There is a tax-efficient order for taking income from investments and pensions. Generally, the following order is best.
Cash (including Cash ISAs)
Stocks and Shares ISAs
Pensions (excluding final salary pension schemes)
It’s best to withdraw income from the least tax-efficient source first including the source which produces the lowest investment return. Currently, that’s cash as represented by your bank accounts. Your bank accounts are subject to Income Tax on the interest unless they are held in Cash ISAs. Also, the interest rate is currently very low and typically less than 1%.
Next in line are other taxable investments. That’s because these investments are already being taxed whether you withdraw income from them or not. Also, tax-disadvantaged investments will usually achieve lower investment returns than tax-efficient ones.
Income from Stocks and Shares ISAs can be taken tax-free unlike income from pensions and ISAs form part of your estate for Inheritance Tax purposes unlike pensions so you should usually take income from such ISAs in preference to your pensions.
Lastly, you should take income from your pensions assuming they are money purchase (defined contribution) schemes the main one of which is the personal pension. Although it seems counter-intuitive to take your retirement income from your pensions last, there are sound tax reasons for doing so.
Pension income is subject to taxation at your marginal rate of Income Tax, in other words up to your highest rate of Income Tax after taking into account all of your sources of income including other pensions such as the state pension. This means after having taken the maximum tax-free cash lump sum which is usually 25%.
Furthermore, money purchase pensions do not usually form part of your estate for Inheritance Tax purposes. Therefore they are the last source of income you should touch. Strange but true.
So there you have it. Guidance on what is a sustainable level of income from your investments and pensions and an order of withdrawal sources. You know it makes sense.*
*The value of your investment can fall as well as rise and is not guaranteed. The contents of this blog are for information purposes only and do not constitute individual advice. You should always seek professional advice from a specialist. All information is based on our current understanding of taxation, legislation, regulations and case law in the current tax year. Any levels and bases of relief from taxation are subject to change. Tax treatment is based on individual circumstances and may be subject to change in the future. This blog is based on my own observations and opinions.