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Taking money from your portfolio: the waterfall method

By Written by Tahir Mahmood, Kim Hinds & Greg Oldfield | 17 Jul, 2023

Taking money from your portfolio is not always an easy choice, if you have a various set of accounts, it can be quite complex trying to determine in which order to withdraw, especially when subject to the US and UK tax rules.

We refer to our tax efficient method of withdrawals as the waterfall methodology.

The methodology can be different for every client as it is based on specific priorities (age, tax residence, income requirements, tax brackets, etc). The method typically follows a predetermined sequence of withdrawals from different sources to meet income needs. Here’s a simplified example of how the waterfall method might work:

What do I need to consider?

This is by no means an exhaustive list but gives some general food for thought on where you should withdraw from. There are so many accounts offering various benefits from the US and/or the UK side that we always urge clients to get professional advice on before proceeding.

  1. Tax-efficient withdrawals: It may be more beneficial to retain assets in the tax-efficient wrappers and draw from taxable accounts i.e., general investment accounts or brokerage accounts in the first instance in order to benefit from the tax advantages of these wrappers.
  2. Early withdrawal penalties: Some investment wrappers, such as pensions or certain retirement accounts, may have penalties or restrictions for early withdrawals before reaching a specific age (such as retirement age). If applicable, consider any penalties or tax implications associated with early withdrawals and plan accordingly.
  3. Required Minimum Distributions (RMDs): If you have retirement accounts subject to RMDs, such as traditional IRAs or 401(k)s in the United States, be aware of the rules and deadlines for taking those distributions. Failing to meet the RMD requirements can result in tax penalties. Therefore, ensure you prioritize these withdrawals when they become mandatory.
  4. Long-term growth and tax deferral: If you have investment wrappers that offer long-term growth potential or tax advantages, such as pensions or certain retirement accounts, it may be beneficial to leave those investments untouched for as long as possible to maximize growth and tax deferral. This can be advantageous if you have other sources of income to cover your immediate expenses.
  5. Estate planning: If you have specific estate planning goals, such as preserving assets or passing wealth to beneficiaries, consider the impact of drawing from different investment wrappers on your overall estate plan. In some cases, it may be more advantageous to prioritize withdrawals from specific accounts to achieve your estate planning objectives.

The typical order of withdrawals

In this article we will look at four main accounts and the order we typically withdraw from:

  1. General Investment Account (GIA)
  2. Individual Savings Accounts (ISA)
  3. Individual retirement Account (IRA)
  4. Self-Invested Pension Plan (SIPP)

General Investment Account (GIA)

A GIA is a standard investment account that allows you to invest in various financial instruments such as stocks and bonds. With a GIA, any income or gains generated from your investments may be subject to tax (capital gains, dividend and income tax) on an arising basis.

A GIA forms part of an individual’s estate in the UK so will be subject to inheritance tax. It also forms part of an individual’s US Estate and so may be subject to US Estate Taxes. The US taxes its residents on their worldwide income and gains and so a General Investment Account will be subject to US taxes.

Individual savings account (ISA)

An Individual Savings Account (ISA) is a tax-advantaged account that allows you to invest in a wide range of assets, including stocks, bonds, and cash, while shielding your returns from certain taxes. Investments held within an ISA are exempt from UK tax. This means any capital gains realized from the sale or disposal of investments within an ISA will not be subject to tax.

The US tax system does not recognise ISAs as a tax wrapper and so, from a US tax perspective, if a US person holds an ISA in the UK, the tax treatment will depend on how the income and gains generated within the ISA are treated under US tax laws. In general, the US taxes its residents on their worldwide income, which includes income and gains generated from foreign investments.

Considering the UK tax benefits that an ISA affords UK tax residents it is more efficient for a US person residing in the UK to take funds or an income from a General Investment Account first. Although both accounts are subject to US taxes there may be UK tax savings that can be made by reducing the UK taxable investments within the General Investment Account before the assets within the ISA, which shields income and gains from UK taxes.

An ISA forms part of an individual’s estate in the UK so will be subject to inheritance tax. It will also both form part of an individual’s US Estate and so may be subject to US Estate Taxes. The US taxes its residents on their worldwide income and gains and so an ISA will be subject to US taxes.

Individual retirement account (IRA)

After the ISA and GIA have ben exhausted, the IRA is normally our next port of call. An IRA benefits from the same tax rules listed in the SIPP below. The reason it is next on the list of accounts to draw from is the RMD rule.

From the age of 72, an individual’s IRA is subject to Required Minimum Distributions (RMDs) which is the minimum amount an individual is required to withdraw from a retirement account,  this is subject to income tax at marginal rates. Given individuals are required to distribute income from their retirement accounts, it is advisable to draw income firstly from the IRA before drawing income from a SIPP.

Self invested pension Plan (SIPP)

The SIPP is generally the last place we draw funds from (for UK resident tax payers) for various reasons:

Compounded tax-free growth: Compounded tax-free growth refers to the ability of investments within a pension wrapper to grow over time without being subject to income tax or capital gains tax. This means that any gains or income generated within the SIPP are not immediately taxed, allowing for the potential for greater long-term growth. It’s important to note that while investments within a SIPP enjoy tax advantages, there are restrictions on when and how the funds can be accessed, typically being available from the age of 55 onwards.

Therefore, by selecting to not draw an income from a pension, an investor could potentially benefit from tax advantages. The money within your SIPP can continue to grow tax-free, allowing for potential investment growth and compounding over time.

Exemption for death benefits: If you pass away before the age of 75, the funds held within your SIPP can usually be passed on to your beneficiaries entirely tax-free, regardless of the size of your estate. This applies whether the funds are taken as a lump sum or as income. However, once the funds leave the SIPP (e.g., if they are moved into an inherited pension or withdrawn), they may become subject to the beneficiary’s own tax liabilities.

Taxation of death benefits after age 75: If you die after the age of 75, the treatment of the funds within your SIPP depends on how they are distributed to your beneficiaries. If your beneficiaries receive a lump sum payment from the SIPP, it is subject to their marginal income tax rate. If they opt for income withdrawals, those withdrawals are taxed as income at their marginal income tax rate.

With the above in mind, in is important to consider that by not drawing an income from your SIPP, you can preserve the funds for future generations. If you have sufficient retirement income from other sources, leaving your SIPP untouched allows you to pass on a potentially larger inheritance to your beneficiaries, such as your spouse, children, or other loved ones.

Wider wealth: Cash Flow Planning

The waterfall methodology is a bespoke method of drawing from your portfolio.

The above sequence of accounts can be variable based on many factors including residency, tax rates, non-dom status, etc.

When a client is looking to start drawing from their portfolio, we would typically conduct an analysis and cash flow model, reviewing various areas to ensure it is the most tax efficient way to do so. Our cash flow models consider all ports whether they are inside of London & Capital or not, and can help put together a plan on how to start drawing an income when required.

If you would like assistance with planning, please do contact us.

To get in contact with London & Capital, please give us a call on +44 (0) 207 396 3388 or click here.

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