Much has been written about pensions A-Day and the potential opportunities for offshore bond wrapper...
Much has been written about pensions A-Day and the potential opportunities for offshore bond wrappers resulting from the impending changes. This article looks at these opportunities in a practical way to try and highlight exactly where opportunities lie.
In a post A-Day world, offshore bonds will not replace pensions any more than other wrappers will. Pensions, especially self invested personal pension plans (Sipps), are still the most tax efficient way to save for retirement and probably offer the most flexibility for investment choice, even after the removal of residential property as a viable asset class. However, when combined with a Sipp, an offshore bond can greatly enhance the effectiveness of retirement planning - maximising tax efficiency, flexibility and freedom of investment choice.
There are certain UK resident individuals who would benefit from the inclusion of a bond wrapper, including:
• Those who have, or who will hit the lifetime limit - they will not relish the thought of a 55% charge on the excess capital, but will still want to save for retirement
• Those who plan to retire abroad - it may be useful to hold some investments outside a pension wrapper for tax efficiency
• Those who cannot benefit from tax relief - for example, non-taxpayers or those whose principle source of income is non-earnings, for example dividends from a family company
• Those who plan to retire early
• Those who do not want to put all their eggs in one basket
Offshore bond wrappers will be key in meeting the needs of the above clients. When investments are held within an offshore bond, the tax treatment is exactly the same as that of a UK pension fund - UK dividends are collected net of a non-reclaimable 10% tax credit, and interest and capital gains are tax free.
Also, the open architecture structure of offshore bonds is in many ways similar to a UK Sipp. Clients have the freedom to select from the full universe of funds in the market or to appoint their own investment manager to construct and run an investment portfolio on their behalf. It would even be possible to view a Sipp and an offshore bond as part of the same retirement plan, so one could build a common investment strategy across both wrappers.
Obviously the major advantage a pension has over an offshore bond is the tax relief on contributions. However, this benefit comes with a price in the form of certain restrictions, including the inability to access the fund until age 55 and, after age 75, the inability to leave the remaining fund to surviving family members.
Additionally, when money is put into a pension, the original capital can be turned into taxable income on retirement. This is because the tax-free lump sum on a pension is limited to 25% of the fund, so the fund would have to grow by 400% before an individual is eligible to receive the original capital tax free. There is also the lifetime limit to consider.
By comparison, the position of an offshore bond is very different. There are no restrictions on the benefits, meaning the client is able to access any benefits before retiring. This is very important if, for example, someone wishes to work part-time from age 50 and gain an additional income. Clients can also leave their remaining fund to their heirs.
Furthermore, the benefits can be taken in a tax efficient way, for example, by owning the contract with a spouse, and splitting the tax bill between two. Pensions are non-assignable, so the tax bill cannot be split in this way. On full encashment, the capital is 100% deductible from the proceeds, which means part of the income will always be tax-free.
Finally, when one takes an income from a pension fund, after deduction of the personal allowance, the income is put through the tax bands. This means the client begins to pay tax at the higher rate after they have used their basic rate band, which is currently set at £32,400.
Offshore bonds, however, have the added advantage of allowing a policyholder to claim top-slicing relief. This reduces the tax bill for those who are in the basic or starting rate of tax where a policy gain takes them into the higher rate of tax. If a client is a non-taxpayer, large amounts of gain would need to be generated before higher rate tax is payable.
Figure1 - this assumes tax bands and allowances grow by 2.5% pa.
Year of Benefit Possible Gain Before Higher Rate Tax Payable
If it seems unrealistic to assume a client will be a non taxpayer in retirement, remember that, post A-Day, it will be possible to take one's tax free lump sum, move the pension into income drawdown, and take nil income. This makes it possible for many individuals to structure their affairs so they have no or little taxable income in the early years of retirement.
Combining offshore bonds with income drawdown increases the opportunity to withdraw gains from policies in a tax efficient manner, as it will be possible for a client to have little or no other income to which the bond gains would be added. The personal allowance and lower and basic rate tax bands will grow by inflation, so more of the gains will escape tax at the higher rate the longer the money is invested.
In addition to offshore bond wrappers, UK residents can also make use of their ISA allowance to build up a capital sum that can be withdrawn totally tax free. Individuals could also consider holding some capital directly in investment funds, which can then be used to draw down capital within the annual CGT exemption.
Therefore, a post A-Day retirement strategy may consist of all four wrappers, which could have a common investment strategy applied across all four and managed by the same investment adviser.
Fig 2: POST A-DAY RETIREMENT STRATEGY
In future, therefore, instead of taking the tax free lump sum from a pension and buying an annuity straight away, an individual's strategy in retirement may consist of opening the boxes in whichever order will give the client the maximum tax efficiency to suit their own circumstances. For example, the retirement strategy could look like this:
By devising a retirement strategy in this way, there is no reason why anyone should be paying higher rate tax in retirement.
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