How to draw down- ISA first or pension first?
Growing the pot
Up until 2021, we had St. James's Place as our financial advisor. I'll talk more about this later, but for now, I want to say that in 2021 we decided to manage our finances ourselves. We moved all our investments from SJP into different Interactive Investor ISAs and a SIPP.
I'm really happy with this decision because I don't think St. James's Place was giving us good value for money. Of course, it's impossible to know for sure how our investments would have done if we had stayed with them, but comparing our growth to the market and benchmarks, I feel confident we made the right choice.
I've always been interested in personal finance, so I was ready to make this decision and make it work for us.
The plan to generate income in retirement
However, what I'm not so sure about is what to do with the money once we retire and need to start using our savings to pay for our living expenses.
As I've mentioned before, my current plan is to buy a fixed-term annuity as soon as we retire to cover us until we start getting our state pension. Then, we'll buy a lifetime annuity to cover our basic expenses beyond what the state pension provides. We'll probably draw down money regularly for any extra spending.
Where to take the money from? ISA or Pension?
The big question for me is how to manage taking money from both our ISAs and our pensions. We have three pensions. The biggest one is in a SIPP with Interactive Investor. Then there's my wife's personal pension and my company pension, both with Aviva. We also have some smaller defined benefit pensions, but they won’t form a big part of our overall retirement income.
This plan could change, and it depends a lot on what annuity rates and tax rules are like at the time.
But the question is, where do I take the money from to buy this annuity? I've read that it's good to use your pension as much as possible before you get the state pension. You can get up to £16,000 per person tax-free each year using the 25% tax-free amount from your pension. This works for taking money out regularly, but I'm not sure if it works for buying an annuity.
Right now, a 10-year fixed-term annuity costs about 8 times the annual income you want. So, if you want £16,000 per year, you need to spend £130,000 on the annuity.
Taking £130,000 from my ISA is simple. There are no tax implications because ISAs are tax-efficient.
Taking £130,000 from my pension is trickier. 25% (£32,500) would be tax-free, but the rest would be subject to income tax and national insurance. So, to get £97,500, I'd actually need to withdraw £140,000. That's a total withdrawal of £172,500.
Or so I thought. But after doing more research, it turns out I was wrong, thankfully! I don't pay income tax when taking money out of my pension to buy an annuity. The income tax only applies when the annuity starts paying out. So, the calculation changes.
Like with the ISA, taking money out of the pension means I'd take out £130,000 to buy the annuity. When the annuity pays out £16,000 per year, 25% is tax-free, leaving £12,000 subject to tax. But this is within my personal allowance, so there's no tax to pay.
So, in terms of tax, it doesn't matter whether the annuity is bought from the ISA or the pension. This is great news and makes things simpler. But what happens later when the state pension starts? The state pension will use up my personal allowance, and any additional income from my pension will be taxed. However, any additional income from the ISA won't be taxed.
I think I want my ISA to be as big as possible when I reach state pension age to reduce my overall income tax.
I think I need to get some professional advice on this now.