Neil MacGillivray weighs up the tax charges on various retirement vehicles.
There is no doubt that enabling a scheme member to take benefits on or after age 75 provides a greater degree of flexibility in terms of retirement planning. Increasing the choices available as to how pension benefits are taken, particularly at a time when the prospect is that annuity rates will remain low, has to be seen as a positive move.
The major downside however is a 55% recovery charge on death of the member on lump sum payments made out of all crystallised funds and un-crystallised funds for members aged 75 or over, is seen by some as excessive. However, is a tax charge of 55% really that unpalatable?We are seeing two distinct courses of action being considered.
Firstly, members who are at retirement age are looking at ways of stripping out as much income from their pension funds during their life where it will be taxed at a lower rate of income tax. For those who will be basic rate taxpayers at the time and will spend the income this is probably the correct course of action. But, if the income they take is going to be taxed at 40% and not spent then it could well be the wrong choice and eventually lead to an overall higher tax charge.
In addition the cost of securing the minimum income requirement (MIR) of £20,000 per annum may be regarded as too high a price to pay to gain access to flexible drawdown. For example, a male aged 65 looking at a single life, level annuity of £15,000 per annum, with no guarantee, to supplement his state pension to achieve the MIR, would have to pay a sum in the region of £250,000* to secure such an income.
Secondly, many members are questioning the actual value of continuing to invest in pensions compared to other tax wrappers such as ISAs and offshore bonds where there are no restrictions in gaining access to the funds invested. Though these should still be fully considered, it is important before making any decisions to look at all the potential tax ramifications. The need for members to seek professional advice and to consider all the potential taxes payable over their life as well as their actual income requirements may lead them to re-evaluate their initial view of what is best.
If we consider the tax implications of a fixed amount being invested annually over a 20 year period in a bank account, ISA, offshore bond and personal pension, the final value of the net funds after all taxation could yield surprising results. The following examples are somewhat basic, and do not consider charges, but their aim is to demonstrate in principle the impact of all taxation on investments over the life of an investor.
A higher rate tax payer investing £10,680 a year into a bank account paying 5% gross (3% net) interest per annum would at the end of 20 years have accrued a total fund of £291,639.
If the same amount was invested in an ISA or an offshore bond given a gross return of 5% pa, the fund would be worth £362,709. The ISA of course has the advantage of being able to access the full fund without any charge to income or capital gains tax.
Under the offshore bond the investor could extract the original sum invested over time with no immediate tax charge, and although deferring income tax, the growth would eventually be taxed as income. Again to keep matters simple, presuming the growth was taxed at 40%, on full encashment the net value of the fund would be £303,065.
A pension has the advantage over the ISA and the offshore bond in that any contributions made, providing they do not give rise to an annual allowance charge and the member has sufficient relevant UK earnings, are paid gross of income tax. The gross annual contribution in this example would be £17,800 per annum; the net of basic rate tax contribution being £14,240 with higher rate tax of £3,560 reclaimed through the investor's tax return, taking the net cost of the annual contribution to £10,680. The fund would benefit from the 5% gross growth as did the ISA and offshore bond.
Not surprisingly, with the benefit of the gross contributions at the end of 20 years the pension fund would be worth considerably more than the other options with a value of £ 604,379. The limitation of course is that normally only 25% of the fund (£151,095) can be taken as a tax free lump sum and, assuming the investor has no major health problems, is aged at least 55.
The remaining fund of £453,284 would be subject to income tax as and when income was taken and on the death of the investor the unused fund at that time, if paid out as a lump sum, would be subject to the 55% recovery charge.
It can be seen therefore that the attraction of stripping income out under flexible drawdown, even if the member is a higher rate taxpayer, may appear an attractive strategy. However, how do the bank account, ISA & offshore bond funds compare net of taxes after the investor's death?
Assuming the client in our examples has other property in excess of the inheritance tax (IHT) nil rate band, then the bank account, ISA and offshore bond funds would be liable to IHT at 40%. The value of the bank account would be reduced to £174, 983, the ISA £217,625, and the offshore bond fund after higher rate income tax and IHT £181,839. So what about the pension?
If the pension commencement lump sum had been taken (and not spent) it would be subject to IHT, leaving a net fund of £90,657. If the crystallised pension fund is paid out as a lump sum it would be subject to the 55% recovery charge and the combined value of the pension fund, assuming the crystallised fund is still worth £453,284, net of all taxes is £294,635, significantly higher than the other options. If benefits had not been taken and the investor died before age 75 then the fund of £604,379 would be available as a lump sum, or if death occurred on or after age 75 the net value of the fund after the recovery charge would be £271,970.
As the outcome of this simple example demonstrates, there may be real value for high net worth individuals to leave their pension funds untouched for as long as possible while running down their other savings to provide income. In reality there is only a minority of people who would have no requirement to access an income from their pension. Where pension income is required, the ability to phase drawdown enables adaptability in terms of tax planning. Equally, taking income from a pension at a lower rate of income tax where it is required is sound advice and, if available, flexible drawdown creates the opportunity to maximise this.
Tax bracket burden
According to the Institute of Fiscal Studies the reduction in the higher rate threshold in 2011/12 has placed an additional 750,000 individuals into the higher rate tax bracket. With further reductions in the higher rate tax threshold planned a greater proportion of taxpayers will move into the higher rate.
Also to be considered is the temporary additional rate of tax at 50% for those with income in excess of £150,000 and individuals earning between £100,000 and £114,950 paying income tax at an effective rate of 60% due to the loss of their personal allowance. This means that more people can benefit from tax relief on their contributions at a higher rate and they should be encouraged to maximise this if they can afford to do so. Taking tax relief on contributions at an individual's highest rate and the pension fund being allowed to grow in a low tax environment still makes pensions an extremely tax effective option.
The recovery charge of 55% does at first glance appear unpalatable, but like any tax it should not be considered in isolation and though it may be a depressing thought it could in fact be considered as too generous.
Neil MacGillivray is head of technical support at James Hay Partnership
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