Phil Carroll looks at how clients may have been affected by the Budget
Changes announced in both the Pre-Budget report and in the recent Budget highlight the need to review existing long-term savings strategies to ensure all clients are taking advantage of tax-efficient financial planning. Following changes announced by the Chancellor, advisers should consider the potential impact on clients and the measures that can be taken for clients who have been affected.
In the Pre Budget report the chancellor announced the freezing of the lifetime allowance so that it and the annual allowance applicable for the 2010/11 tax year will remain unchanged until the end of 2015/16 tax year. Although the freezing of the annual allowance at £255,000 will only affect a small percentage of those making pension contributions, the freezing of the lifetime allowance at £1.8 million has the potential to affect many more. Whether these allowances will increase in the future remains to be seen.
Consider an investment of £330,000 held within a personal pension for an investor who has 25 years until their desired retirement date. If 7% growth (net of charges) is achieved and the lifetime allowance remains static beyond 2015/16 then the fund will be right on the cusp of the £1.8 million lifetime allowance.
While the growth referenced in the example above is merely an assumption, it certainly needs to be considered in any recommendation. To continue funding at existing levels could carry the potential risk that some clients will face a future lifetime allowance charge currently of 55% (for funds above the lifetime allowance where capital is taken), or 25% charge (when the excess value is taken in the form of income which is in addition to any income tax liability generated from the additional income).
Accepting that clients have received the appropriate advice and have registered for primary or enhanced protection ahead of the 5 April 2009 deadline, what options are available to clients approaching the £1.8 million lifetime allowance mark?
The challenge of change
If the Pre Budget announcements were not challenging enough, the April Budget and subsequent Finance Bill added the further complexity of a 50% income tax rate from 2010/11 and the removal of higher rate tax relief on pension contributions for those with relevant incomes (not earnings) over £150,000 per annum. The detail on how this will be managed will no doubt be discussed in the coming months, but clearly the existing pension planning model needs to be reviewed. For some clients, their level of pension provision may well need to change.
These changes raise some questions: Should clients that are affected stop saving money into their pension? What alternatives should clients consider when redirecting funds that were previously earmarked for pension provision? What if the allowance is increased in future years?
For many such clients, ISA allowances will probably be fully funded already, and other areas of tax efficient investments such as national savings certificates may also have been utilised. While accepting that each investor's appetite for risk will vary, it would be fair to assume additional investments might have some form of equity or growth exposure.
If one is only considering mainstream investments, it would appear that funding a UK-authorised investment fund (AIF or collective), single premium investment bond or even a maximum investment plan (MIP) could offer the equity exposure and flexibility to ensure the savings habit is not lost.
Making use of an MIP
While the MIP may have declined in mainstream popularity, it still remains a useful investment vehicle for those with limited but high-earnings periods or for clients who suffer restrictions on pension contribution levels due to proposed changes. With the proposed phased loss of the personal allowance where income exceeds £100,000 and the 50% income tax rate for those with income above £150,000, the MIP may well regain some of its lost popularity.
An MIP is a pre-certified (by HM Revenue & Customs) qualifying savings plan that can shelter investment profits from future income tax rises. It offers diverse investment exposure, no ongoing reporting requirements and provides an income taxed at the equivalent to basic rate after the qualifying period. In the hands of a higher rate tax payer an MIP carries no personal tax liability on income or capital gains. Contributions also provide peace of mind in the form of limited life cover, and an MIP could offer a solution for some clients where pension funding may need to be reduced.
In recent years headline capital gains and income tax rates have been falling but, as already stated, the current proposal to introduce a 50% tax rate for income over £150,000 alongside the loss of all or part of the income tax personal allowance over £100,000 may mean the tide is slowly turning back.
An MIP normally invests into a UK authorised investment fund (collective investment) held as a UK life fund which suffers corporation tax in the hands of the life company. The actual rate suffered within the life fund may be less than the basic rate due to the way life fund taxation is calculated.
Due to the lack of tax relief on contributions made and ongoing taxation at a rate currently less than 20% per annum, an MIP may not look as attractive as a pension depending on the client's income. However, pension income is currently taxed up to 40% and tax free cash, once received, will lose its exempt investment status and will require a new (and potentially taxable) home. Access to the pension fund is also limited by a normal minimum pension age that will increase to age 55 from next tax year.
Funding over the lifetime allowance comes with a potential tax rate of 55%, whereas if the capital is not required from the MIP, it can be assigned easily out of the estate for inheritance tax purposes, not something easily achieved with a pension. For those with high income levels in retirement, avoiding tax at 40% or even 50% could make the MIP an attractive alternative for additional funding and provide a tax solution that clients are looking for.
The MIP approach differs significantly to investing into a UK authorised investment fund (collective) or single premium investment bond. The bond vs collective argument has been much discussed. But often the choice of investment wrapper will be decided on issues wider than 18% versus a possible 50%. The extraction rules for either wrapper differ significantly but either route can offer tax-efficient withdrawal strategies depending on client circumstances. There are further tax planning strategies to be addressed at the underlying investment level, which may help address the lack of tax relief available for any investment into an MIP, bond or collective.
For many investors who are looking for alternative investment vehicles to complement pension provision, choosing an investment that produces real income is likely to mean an increase in their income tax liabilities, especially when incomes exceed £100,000. The marginal rate of tax on income in the current tax year between £100,000 and £112,950 will be 60% due to the loss of the personal allowance at this level. The net proceeds can be re-invested, however if income was sheltered inside a bond, this could offer better returns.
The reverse is true for capital growth. With a flat rate of capital gains of 18% and the use of an annual exemption, the investor could realise significant gains from a collective free of capital gains tax year on year.
Alternatively, the 5% tax deferred withdrawal from a bond could be attractive if the bond is still retained in retirement. These withdrawals will not be classed as income and will not affect entitlement to any available increase in personal allowances. Unused 5% allowances could be rolled up and used to provide a lump sum to top up any pension shortfall should the lifetime allowance increase in the future or the pension performance be lower than expected. Realising future bond gains in a year when no or only a minimal income is taken, for example, may significantly reduce the actual amount of tax paid on any realised gain.
The need to have flexibility as well as an alternative "income" stream in retirement may well mean that one or a combination of these wrappers could be a suitable model to meet varying client needs going forward.
Where a combination of wrappers is considered, creating efficient client portfolios is essential. Ensuring that the right mix of income-producing or growth-orientated collectives are held in the right wrapper will further benefit the tax efficiency of any strategy. This could go some way in making up for the lack of any income tax relief on contributions to the wrappers previously described.
Following the requirement for action on primary and enhanced protection and the wider implications of this year's Budget, using alternative wrappers to achieve client goals in retirement has further underlined the need for quality advice.
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