Is the 4% pension drawdown rule before or after tax?

Hi Heather

I’m really enjoying your podcasts and have already given a 5 star rating.

I am 57 and plan to retire at 60 so love your retirement items.

When talking about 4% draw down for retirement income, it’s never clear if the figures are before or after tax. For example 4% of £1m is £40k, but after tax this could be nearer £30k.

If you then get a state pension of say £9k, the figure before tax is £49k, but after tax it is nearer £35k.

So when you talk about money needed in retirement, do you mean before or after tax?

Thanks,

David

The Money Spot™ - UK Personal Finance · #30 Is the 4% pension drawdown rule before or after tax?

David, thanks so much for the review! I definitely appreciate it.
 
First things first, David I am sorry that it’s taken me ages to get a blog post done on this, however, I did respond to your question directly within 24 hours of you asking it so I hope that will make up for the late blog post response to your question which you asked me roughly 3 months ago and 4 months ago by the time this airs on The Money Spot podcast.
 
Turning to the 4% rule…
 
For those that have not ever heard of it, the 4% rule states that if you don’t want your pot of invested retirement funds to run out before you die, the maximum you can take from that pot each year is 4%.
 
This means that if you want an annual income of 40,000 from your retirement pot, you need to save one million (GBP, USD, EUR) – I believe the study was done using American stock market performance but if you invest in a global portfolio it will be heavily weighted towards the US so you can use the 4% rule as the best proxy we have on what a reasonable withdrawal rate is.
 
To answer, David’s question, the 4% drawdown is gross and you would have to pay tax after that.
 
So, if you have £1,000,000 (for simplicity) in your pension pot in a given year, you would draw £40,000 and pay the tax on that.
 
If you are based in the UK, you cannot throw the gross amount drawn from your SIPP or other taxable investment account into listentotaxman.com to get a calculation of your after-tax income because your drawings from your investments are chargeable to capital gains tax so you don’t pay income tax on them but capital gains tax. Capital gains tax rates are different. In 2020, assuming 50% of the £40,000 you draw is capital gains, then your net income after tax would be calculated as follows:

 
Not taxable:                                  £20,000 (this is the portion you actually saved)
Taxable:                                          £20,000 (the capital gain)
Deduct capital gains tax allowance:               (12,300)
Taxable:                                            £7,700
 
This taxable amount all falls into the basic rate band for 2020/21 so you’d pay tax of 10% on it, i.e. £770. If you had a portion in the higher rate tax band even that is only taxable at a rate of 20%.
 
So, out of the £40,000 the net amount received would be £39,230.
 
This is a huge different to what you would have paid if this was income of £40,000 as the net income would have amounted to £30,841. That’s a difference of £8,389 – wow! People on work place pension will be taxed in that way because the DB pension counts as income, you can’t separate it into capital and capital gain.
 
 
If you are UK based and have reached your state retirement age then you would have an annual state pension. This is taxable to income tax and you can throw the total annual state pension amount that you receive into listentotaxman.com to figure out how much you will receive after tax.
 
State pension is taxable if all your sources of income sum exceed the threshold needed to pay tax.
 
That annual state pension is just over £9,000 so if that’s your only source of retirement income you wouldn’t pay any tax because it’s below the personal allowance of £12,500 – however, if this is you, you probably wouldn’t be the type of person that listens to personal finance podcasts - #JustSaying.
 
A few BIG things to remember though:
 
ISAs
 
If your retirement income is all in your ISA then it is all tax free; not tax needs to be paid.
 
Capital gains tax allowance
 
Current tax rules allow you to have a tax free allowance on capital gains in addition to the tax-free personal allowance SO your tax bill may be much less than you think because your state pension and any other pension income may fall into the regular income bucket and this enjoy a separate tax free allowance.
 
For 2020 the Capital Gains tax-free allowance is £12,300. I don’t know if this will be available when I retire, there’s talk of eradicating it to raise more tax…
 
Early retirement
 
Those that retire very early, and I’d classify anything before 55 as early may be overdrawing if they draw 4% because the study of the 4% rule was based on a 30-year retirement.
 
David, you’re probably okay given you’re 57.
 
Sequence of returns risk
 
Sequence of returns risk analyses the order in which your investment returns occur.
 
If a high proportion of negative returns occur in the beginning years of your retirement, these negative returns will have a lasting negative effect  on the balance of your investment portfolio and the amount of income you can withdraw over your lifetime is reduced. This is sequence of returns risk. However, if you have a few years of good returns when you retire and negative returns only occur later, say in the middle of retirement, then there’s a lasting positive impact.
 
If this happened to me, I would probably stop drawing income from my retirement pot for 2 or 3 years and live off non-stock market income, e.g. if you have  cash pot set aside, I’d deplete that first; or I’d consider getting a part-time job; or for those fortunate enough to have rental income, you can live on that and give your investment portfolio time to recover.
 
I think that’s all the main stuff. To summarise:

1. The 4% rule is gross so tax needs to be deducted after you draw 4% from your investment portfolio.
2. No tax is due if all your investments are held in an ISA;
3. Even if the retirement investments are in taxable brokerage account, you have a healthy Capital Gains tax-free allowance of £12,300.
4. The 4% rule may not work if you retire early because it wasn’t tested on long retirements.
5. Finally, sequence of returns risk means that if stock market returns are poor in the first few years of your retirement, the value of the income you can draw during your retirement years is reduced.

 
I hope this answers all your questions and I additionally hope that I threw in a few thoughts that you hadn’t considered.


Heather 
p.s. subscribe to my podcast and ask me any money question, HERE - do it now!