Nigel Orange highlights the importance of taking a holistic approach to retirement planning
The degree of specialisation available for retirement planning probably varies considerably. This could depend on how much of the advice relates to a client's pension arrangements or if estate planning is at the core of advice.
In truth, most clients seeking advice will have a range of investments and assets, including their home. This will necessitate a holistic approach requiring a good knowledge of estate planning.
Meeting all of a client's objectives can be an impossible task after assessing risk and capacity for loss. Needless to say, managing a client's expectations from the outset is fundamental to avoid client disappointment at some stage in the future.
More often than not, one of a client's core objectives is to protect their accrued pension benefits from the taxman in the event of dying prematurely. Meeting this objective while delivering the desired pension income at the same time can be a challenge.
Although the Finance Bill 2011 generally removed inheritance tax (IHT) charges from pension benefits, a special lump sum death benefits tax charge of 55% can be more punitive than the previous taxation regime, so avoiding this charge would be an important factor to consider.
Even when this lump sum death benefit has been paid out to the spouse free of tax, IHT can still affect their estate on the death of the spouse.
But with some careful planning, IHT can be mitigated by setting up a spousal bypass trust. I am not going to cover this topic now, focusing instead on the challenge of delivering tax-efficient income while at the same time maximising lump sum death benefits.
The case study below is probably not untypical of many clients who are seeking retirement advice and solutions about:
• Investing capital for a tax-efficient income
• Providing tax-efficient pension income while protecting lump sum death benefits
• Estate planning.
The facts of the case
John is a higher rate tax payer, aged 65 and married to Janet (aged 55, a non-tax payer). He is about to retire and has the following assets, including a pension in payment:
• An uncrystallised SIPP valued at £500,000
• An occupational defined benefit pension, paying a gross yearly income of £16,800, with a 50% spouse income on his death
• A yearly state pension of £5,728 gross
• An investment portfolio (including ISAs, shares and collectives) providing John with additional gross income of about £5,000 each year
• Inherited assets of £175,000
• A matrimonial home valued at £750,000.
• John requires a gross yearly retirement income in the region of £60,000
• John has three children, all in further education, and wants to make sure that if he were to die prematurely, his assets, including his SIPP, would be available to provide income for Janet. John would also like his children's inheritance to avoid unnecessary tax
• His other priority is to help his children purchase their first home.
John's shortfall in income
John's current gross retirement income is £22,528 (occupational + state pension) + £5,000 from his investment portfolio, making a total £27,528, leaving a shortfall of roughly £32,500 (gross).
John's options to meet the shortfall in retirement income
1. Take an uncapped income from his SIPP drawdown – this is possible because John already meets the minimum income requirement of £20,000 per annum required to qualify for flexible drawdown
2. Invest all or part of the £175,000 inheritance to provide additional income and, at the same time, capital for his children's house purchase – John's investment portfolio, including ISAs (with the yearly maximum of £11,520 being used), is already providing the majority of John's investment income
3. Combination of both 1 and 2.
John's assets, excluding his pensions, are potentially subject to IHT as part of his estate, which is already in excess of the current nil-rate band (£325,000).
But should he die first, his assets would pass to Janet under the terms of his will – which would be exempt – so no immediate IHT would apply. John could decide to gift some capital to his children, but he is reluctant to do this at this stage.
Option 1(above) is the most obvious way to meet any income shortfall. But if John crystallises all his SIPP into a flexible drawdown arrangement, on his death, the balance of his pension fund would be subject to the special lump sum benefits tax charge of 55%, even though usually no IHT would apply.
Investing all his inheritance into his investment portfolio might leave John short of risk-free capital should he need it in the short term for a house deposit. Income tax would apply on his pension income and also on part of his investment portfolio.
Capital gains tax would potentially apply to any gains made on collectives or shares held in the non-ISA part of the portfolio if realised. Income tax could also apply to investment bond chargeable gains, but John does not currently have any investment bonds.
Crystallising only part of the SIPP to provide additional pension income, and with additional investment income coming from reinvesting part of John's inheritance, seems the best solution to make up the shortfall in a tax-efficient way. If John sets up a phased flexible drawdown from his SIPP, this would limit the amount of any lump sum tax charge in the event of John's death.
He could also consider making further contributions to his SIPP (at least up to the maximum allowed figure of £3,600). This would cost John only a net £2,160 after tax relief, and 25% of the fund can be taken tax-free as part of his pension commencement lump sum (PCLS). John could carry on contributing this amount up to age 75.
Additional investment income
If John were to invest £150,000 of his inheritance (leaving £25,000 as readily available capital) – for example, in an offshore bond – this would benefit from gross roll-up similar to that enjoyed in a pension fund.
John could then take up to £7,500 tax-deferred withdrawals each year. He can then, at a later stage, assign the policies over to his wife (who is a non-tax payer), reducing or avoiding any tax liability.
This strategy also has the advantage that it is generally less burdensome than investing into collectives. Switching funds is straightforward and comes without the tax calculations required for reporting on self-assessment tax returns.
John would have £25,000 left in short-term deposits for emergency needs, and should his children want to purchase a house – which would not be for at least five years – he could then assign segments of his offshore bond either to Janet or his children. This strategy would increase John's overall income to £35,000 (£27,528 + £7,500), leaving a shortfall now of roughly £25,000 per year.
Income of £25,000 per year from a phased flexible drawdown
If John gradually crystallises part of his SIPP by phasing into a flexible drawdown and taking his PCLS entitlement each time, he can take tax-efficient income while preserving his lump sum death benefits up to age 75.
Beyond this age, any lump sum death benefit would automatically incur the 55% lump sum tax charge.
Because John qualifies for flexible drawdown, he has the freedom to take as much or as little income from his pension as he sees fit without the maximum income restrictions applying to a capped drawdown arrangement.
Assuming John's SIPP is valued at £503,600 (after his maximum tax relievable contribution), he only needs to crystallise an amount from the SIPP to satisfy his immediate income needs – £25,000 per year, with 25% being made up from the PCLS.
Assuming growth on John's SIPP fund were to average about 5% each year, he could easily preserve the value of his lump sum death benefits up to age 75, which was part of his core objective.
He could withdraw higher or lower amounts if necessary, depending on how his overall investments were performing, but bearing in mind any pension income would be taxed at his highest marginal rate.
For example, the income could flow along the lines of the table below. (The table assumes for simplification purposes, no imposed minimums for crystallisation or charges for flexible drawdown.)
Age Annual gross pension contributions Phased SIPP fund at start of each year after pension contribution Target yearly income and crystallisation amount PCLS Flexible drawdown income Phased SIPP fund at end of each year
after withdrawals and 5% annual growth
65 £3,600 £503,600 £25,000 £6,250 £18,750 £503,780
66 £3,600 £507,380 £25,000 £6,250 £18,750 £507,749
67 £3,600 £511,349 £25,000 £6,250 £18,750 £511,916
68 £3,600 £515,516 £25,000 £6,250 £18,750 £516,292
69 £3,600 £519,892 £25,000 £6,250 £18,750 £520,886
70 £3,600 £524,487 £25,000 £6,250 £18,750 £525,711
To conclude, achieving a desired income level while trying to protect pension funds from the taxman in the event of death requires positive but only modest investment performance.
Flexible drawdown means being able to self-determine income levels, and this makes the challenge a good deal easier to meet.
Nigel Orange is technical support manager (pensions) at Canada Life
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