This is Part 2 of our Retirement Withdrawal Strategies series. Part 1 is here.
Or at least, get pretty close to paying nothing – might be hard to completely escape the tax man when you have to work in two systems at once!
For a sample £900,000 portfolio at retirement, the difference between a good withdrawal strategy and a sub-optimal one could be the difference between paying less than £30,000 in taxes over 40 years, or paying more than £300,000.
Got your attention? Good – this seemingly esoteric topic can really make a difference to how much you have to spend in retirement, or however else you might want to use your money.
I need to give credit to Go Curry Cracker – his post on never paying taxes again inspired this one, but we need to extend it to include consideration of the the UK tax system. If you haven’t read his post, I encourage you to take a look and then come back here.
A quick recap of his four rules for not paying taxes:
- Choose leisure over labor: applies to Americans in the UK just as much as anywhere else. Just like the US, the UK tax system takes much higher taxes from people with income from wages than it does from capital gains or dividends.
- Live well for less: the less money you spend, the less you need. In the UK, you could get up to £31,870 a year per person, totally tax free. That doesn’t even include tax-free income from ISAs or Roth IRAs, and 25% tax-free from pensions. The average household in the UK spends around £31,200 – if you can live within double the average spending (as a couple), you may be able to do it without paying a penny.
- Leverage Roth IRA Conversions: this still applies, if you have US retirement accounts (401(k), IRAs, etc.). These conversions (probably) aren’t taxed by the UK, and if you can stay below the US’s standard deduction of $24,800 (MFJ), they can be tax free in the US, too. That means you can take the money you saved (often without paying tax on it, like in a 401(k)), convert it to a Roth IRA without paying anything, and then withdraw it, still not paying anything.
- Harvest Capital Losses and Capital Gains: applies just as much in the UK as the US. With the £12,300 UK capital gains exempt amount plus 0% US capital gains rate up to $80,800 (MFJ), there’s ample opportunity to get your capital gains for free.
Your Tax-Free Buckets
Both the US and UK tax systems have a variety of allowances, below which you don’t pay any tax at all. The short answer to minimizing your taxes in retirement is to keep your income within these buckets – anything that spills over gets taxed.
Your UK tax free buckets (if you’re married, you each get these, but you can’t share):
- £12,570 personal allowance: covers almost everything, but especially wages (including deferred wages, like in a pension or 401(k))
- £12,300 capital gains annual exempt amount: just capital gains (the UK doesn’t distinguish between long and short term)
- £2,000 dividend allowance
- £5,000 starting rate for savings: just for savings interest, you only get this if your other income is under £17,570 (it tapers from £5,000 to £0 between the personal allowance and £17,570)
- £1,000 personal savings allowance: also just for savings interest; this drops to £500 if you enter the additional rate income tax bracket, and £0 at the higher rate level
Also worth a quick reminder of what the taxes are if you exceed those limits (this is a simplification, but close enough for us):
- Wages & interest:
- 20% basic rate above £12,570
- 40% higher rate above £50,270
- 60% effective rate between £100,000 and £125,140 as the Personal Allowance phases out
- 45% additional rate over £150,000
- 7.5% if your overall income puts you in the basic rate
- 32.5% higher rate
- 38.1% additional rate
- Capital Gains:
- 10% if your overall income puts you in the basic rate
- 20% higher and additional rate
- Changes to 18% and 28% if the asset is residential property
The US has a similar system, although slightly fewer but bigger buckets. Big caveat is that most of the time, your UK taxes are higher than US, and Foreign Tax Credits will mean that you pay nothing to the US.
There are only a couple of common instances where the US taxes you on something that the UK doesn’t, and thus you may not have any FTCs to offset US taxes: ISAs and Roth Conversions (probably).
I’m using Married filing jointly numbers throughout – Single and Married filing separately are mostly half of the MFJ, with Head of Household in between. The US lets couples share 🙂
- $24,800 Standard Deduction: covers almost everything
- $80,000 capital gains 0% rate: covers long term capital gains and qualified dividends. This is on top of the Standard Deduction, but if your other income goes over $80,000, this pushes you in to the 15% rate
And if you go over those tax free buckets, you get taxed at:
- Wages, Interest, Short Term Capital Gains, & Ordinary Dividends:
- 10% up to $19,900 above the standard deduction
- 12% from $19,901 to $81,050
- 22% from from $81,051 to $172,750
- And up from there, topping out at 37% above $628,301
- Long Term Capital Gains & Ordinary Dividends
- 15% from $80,001 to $496,600
- 20% above $496,601
- There’s a few exceptions at 25% and 28%, for collectibles, some small business stock, and depreciable real property – we’ll ignore those
Filling your buckets
Quick example – we’ll get into more details in future parts, but let’s see how this could work for just one year. Let’s say that Polly and Pat are 60 years old, have stopped working, and have savings across a variety of accounts: Traditional IRA (rolled over from a 401(k), Roth IRA, UK pension/SIPP, S&S ISA, and a taxable brokerage account. And they’d like to spend £48,000 this year – that’s 1.5x the national average, and probably a pretty comfortable retirement.
Let’s fill up their buckets and see how they can avoid paying any tax, plus planning for the future. Remember that UK taxes are always filed separately – they don’t get to share allowances as a couple (very small exception for the marriage allowance – we’ll ignore that for now).
- Polly’s buckets:
- £5,000 personal allowance: she fills this from her tax deferred accounts – Traditional IRA, Traditional 401(k), UK Employer Pension, and/or SIPP. If you use the Employer Pension or SIPP, you can actually take £16,750 before paying tax, because 25% of the withdrawal is tax free. We could use more, but we want to keep our US taxable income low, we’ll see why. In a future part, we’ll see why she probably wants to use her US Traditional accounts first (hint: RMDs).
- £5,000 capital gains annual exempt amount: from your taxable brokerage account (US or UK). We could use up to £12,300, but Polly doesn’t have enough gains in her account to do that. Because this is just on the gain, let’s say Polly actually gets £15,000 to spend, but she only includes the gains on her taxes.
- £1,000 dividends allowance: also from her taxable brokerage account. Again, Polly’s account isn’t big enough to use the full £2,000.
- £3,000 from tax free accounts: S&S ISA, Roth IRA, and 25% of your UK pension/SIPP. We use this to make up the balance – it’s the last place to go after filling up your buckets as best you can.
- With the starting rate for savings or the personal savings allowance, whatever Polly has in taxable savings accounts is likely tax free (at a 1% interest rate, Polly could have up to £600,000 in cash before paying tax – you probably don’t want this much cash!)
- All total, that’s £24,000 from Polly without paying a cent
- Pat does exactly the same – maybe Pat has a slightly different mix of accounts or balances in each, but the same principles apply.
- This does get more difficult if one spouse has much higher balances than the other, for example if one had a long working career and the other did a mix of full time working, unpaid work at home with young kids, part time work, etc.
- Together, Polly & Pat have £48,000 to spend, with no UK tax due.
Let’s take a quick look at this from the US side (I’m assuming a pound buys $1.40):
- Standard deduction: $14,000 from tax deferred accounts is less than $24,800 – no tax here
- Looking to the future, Polly & Pat use the remaining $10,800 for a Roth conversion – they pay no taxes now, because they’re under the standard deduction, and when they want the money at least 5 years in the future, it’s tax-free.
- Capital Gains: £10,000 capital gains + £2,000 dividends + maybe £2,000 of the tax free accounts is capital gain on a S&S ISA, which is US taxable. Total of $19,600 – way under the $80,000 0% capital gains rate
- Again looking to the future, Polly & Pat harvest some more of their capital gains – £7,300 each, until they hit the UK limit. That’s an additional $20,440 here, still well below the point at which they pay any US or UK tax. And now that they’ve realized those gains, they don’t have to pay tax on them again. In practice, they probably sell one stock/fund and buy a slightly different one – that money is still invested and growing, but starts the capital gain calculations over from zero.
Conclusion & Next Steps
By managing our retirement income based on the tax-free buckets provided by both the US and UK and living slightly modestly (at about the 80th percentile of household spending – not THAT modest!), we can avoid paying any tax this year, and set ourselves up to continue paying no (or very low) taxes for the rest of our lives.
In Part 3, I’ll put together the approach to not paying taxes with the phases of retirement – each phase needs a different approach, and has a few unique pitfalls to avoid.
In Part 4, I’ll wrap it all together with some scenarios and examples of how an entire retirement’s worth of withdrawals can look, and how following a sensible plan could save hundreds of thousands in tax for a typical retirement.