You should have already spent time identifying the gap between your secured income and your required spending needs. If you have more secured income than you need to spend, congratulations.
Most of us, though, will have a shortfall between the amount of secured income coming in and what we’d like to spend to live. That shortfall will likely be biggest at the start of our retirement, because many of us will have income sources kicking in at different times, not least the state pension.
Identify Your Cash Needs for the First Three to Four Years
I think it would serve you well to identify your cash needs for the first three to four years after you technically retire. Once you have done this, you can think about where you should take it from.
Do you have enough in cash already? If so, will you use it all up, or will there be any left? Are you happy with your answer, or do you need to draw some from either your pension or other investments? If so, should it come from the tax-free cash available within your pension, or from somewhere else? You need to know what cash you need before you can optimise where you take it from.
Use all Available Tax Allowances
Much of this will depend on the amount of money you have in pensions and investments, and the wrappers in which the money is held. The obvious allowance to use is the income tax personal allowance, which at the time of writing is £12,500 per year.
If you retire early, you may have no earned income at all, and this is a great opportunity to get money out of a pension which is taxed as earned income, but to pay no tax on it. Don’t neglect the annual capital gains allowance too.
If you hold money outside of pensions and ISAs, then this can be a way of getting money out of your investments and paying no capital gains tax on it. Right now the annual allowance for CGT is £12,000, but this changes each year usually.
After that, your options are fairly limited. Most of us will only have pensions and ISAs, and as you know there is no tax on taking money out of ISAs at all. If you happen to have spending and income requirements that might mean you pay higher rate income tax on your pension drawings, then do at least try to pay tax only at 20%. Draw what else you need from other tax-free sources – no sense in throwing money away in tax.
Wondering if you really need tax-free cash? Or want to know if it's possible to have a life post-work?
Hi Pete. Thanks for all the amazing advice.
I have a problem with the cash ladder strategy that I need some help with.
2 issues:
1. Good plan to keep the first 2 years of spend in cash to allow 2 years worth of a market downturn to ride out. However, the plan says to review the portfolio once per year. In this case, every month that goes by the cash pile is reduced. So if there is a market downturn 10 months in, we now only have 14 months of cash to ride it out. Surely we need to review the ladder monthly or at the latest quarterly and move money back into the cash section to stay safe.
2. The 2 years safety cash also has a critical limit. Let’s assume we do have a downturn and the cash pile does it’s job and gets used up but now the market has recovered. To live over the coming year we now need to drawdown from the pension……fine because it has now recovered and we can sell without loss. HOWEVER the cash pile now needs to be replenished otherwise another downturn will kill us. But we cannot replenish it as we will need to pay 40% tax if we drawdown enough to live for the year AND replenish even 1 year of the 2 years cash( I suspect the original downturn would not have cost 40%!!). This needs a lot of planning as it will take years to replenish if only 20% tax is paid. And in those years we will be exposed again to a downturn. So…… we need to be clear that this strategy has complexities that need to be managed… and prepared for. What do you think?
I agree Jeff – there are many complexities. The scenarios you speak of are the reasons why I also make sure that in the years 3-5 sections of the ladder, I opt for separate equity and bond holdings, the thinking being that I could draw off the hopefully less affected bond portion if markets are still in decline. It will be impossible to avoid some element of selling at a loss without some serious luck over the years – the ladder hopefully gives the best chance of doing so.