Jeremy Pearson takes a look at the tax advantages of employing a decumulation strategy that takes all savings vehicles into account
For the high net worth individual needing retirement income, the old days of filling your pension arrangements to bursting and taking a huge pension are past. This is mainly because people are now only allowed to accumulate pensions savings at a maximum of £40,000 per year (ignoring carry forward) with tax relief and when they come to decumulate, anything over the lifetime allowance suffers punitive taxation (unless protection is in place).
Added to that, we currently have rock-bottom yields for drawdown and annuity rates; with the income produced being taxed at a marginal rate of up to 50%. It does not end there either, as any return of capital as a lump sum death benefit from drawdown, the lump sum will be taxed at 55% regardless of age.
So we have the situation where, as unlikely as it sounds, a pension plan might not be the best way to provide retirement income! In fact, using other assets instead can be more tax efficient.
Rather than expound theory, this assertion can best be illustrated by means of a case study. Let me introduce you to Tom, a wealthy individual. After a successful business career, he has reached 60 and has decided he has had enough of work. He now wants to pursue other interests and has worked out that he will need approaching £100,000 income (each year) to do so.
Just like every client you meet, Tom does not like paying tax - especially as he paid loads of it when in business. He is well aware a pension would be taxed at his highest marginal income tax rate and is receptive to other suggestions that would be more tax efficient.
The way of doing this is actually to make capital realisations on a regular basis. It is a bit more labour intensive than setting up a monthly annuity, but the tax-saving rewards are worth it.
The first thing to do is find out just what assets are owned by Tom. He had been soundly advised to have a spread of investments, in a variety of tax ‘wrappers', with the aim of taking the benefits when it best suited his circumstances.
His current assets are as follows:
Offshore bond £600,000
We know he needs £100,000 income each year. He is only taking investment income of £3,000 gross on his OEICS, his ISA income being reinvested.
He has stopped working and his state pension does not start for another five years. If he simply crystallised his SIPP, his pension commencement lump sum would fund two years' tax-free income, but thereafter the more income he took the more tax he would pay.
|Annuity income||Effective rate of income tax|
The experienced financial planner would probably point out that, of course, phased crystallisation would be a more tax-efficient way of providing retirement income, but Tom's adviser has another suggestion - no crystallisation at all.
Tom's adviser suggests he takes ‘income' as follows:
• SIPP income of £0
• ISA income and encashments of £8,000
• OEICs dividends (gross) of £3,000
• Full encashments of individual OEICs of £17,000 (with a capital gain of £10,000)
• Offshore bond encashments of £72,000 (with a chargeable gain of £24,000 - see below)
Let us look at the tax implications of each of these suggestions in turn.
Although there is the temptation of taking the pension commencement lump sum (PCLS) and nil income, through drawdown, that would make the residual fund subject to the 55% recovery charge on any lump sum death benefit.
In addition, the fund is tax-free - although it suffers withholding tax. It could also be paid IHT free on death.
Another tax-free fund, except for any withholding tax, unless you are an estate planner who knows differently, IHT being the only personal tax that the ISA is not automatically free from.
At present, Tom is reinvesting his ISA income but could choose to have it paid out instead. Coupled with a withdrawal of funds, he could take £8,000 with 0% tax.
His OEIC produces £2,700 net in dividends from a portfolio of equity funds, which currently arises in accumulation units.
Tom's adviser recommends that he switches his equity income funds from accumulation units to income units and banks the income distributions.
Tom is entitled to an annual exempt amount of realised capital gains, before he pays tax at 18% or 28%.
This is a ‘use it or lose it' exemption, so it makes sense for Tom to take some profits on his OEICS without tax.
These gains have to be within the limit of £10,600 for 2012-13. This will probably reduce his OEICS yearly income as well.
Offshore bond encashments
Many have contemplated the question of investment bonds or collective investments for clients.
In truth, the answer is a bit of both in most cases, but the crucial factor with recommending investment bonds - where taxation can be deferred for many years - is to have an exit strategy. This is even more vital for offshore bonds, where chargeable gains are taxed at the policyholder's full marginal rate.
In Tom's case, the cessation of his earned income is an excellent exit point. This is because so far, the adviser's recommendations have only generated £3,000 of taxable income - and that income is taxed after offshore bond gains, which saves more tax.
It is far better for Tom to offset taxable gains against his personal allowance rather than dividends with unrecoverable 10% withholding tax.
The UK tax system
To explain that last point, I have to take a diversion from our case study into the wonderful world of income tax. A necessary evil that has to be common knowledge for a financial planner.
When HMRC is working out someone's income tax bill, it cumulates that person's income in a certain order:
1. Non-savings income, for example, income from employment or self-employment, or property income
2. Savings income (includes bank and building society interest, and gains made on life insurance policies (without a ‘notional' tax credit - offshore bonds))
3. Dividends and tax credits
4. Taxable lump sum payments
5. Gains on life insurance policies with a ‘notional' tax credit - onshore bonds
So, for example, the earned income may be taxed at basic rate but the dividends taxed at higher rate because the total at that point exceeds the higher rate tax threshold.
The interesting fact from the point of view of the suggestion made to Tom is that the offshore bond chargeable gains are before dividends, allowing him to offset them against his full personal allowance.
Offshore bond tax calculation
It was stated above that Tom had offshore bonds worth £600,000 and it has been suggested he encashes £72,000 of these. The bond investment was £400,000 and it has 100 policy segments. The chargeable gain calculation is as follows:
• Current Value = £600,000
• 12 segments encashed = £ 72,000
• Segment value = £6,000
• Less original investment = £4,000
• Segment chargeable gain = £2,000
• 12 segments, so total gain = £24,000
So that is the chargeable gain, what is the actual income tax bill?
Firstly, Tom's income is all savings income, so he will benefit from the 10% starting rate for savings income.
This means that the first £8,105 of the offshore bond chargeable gain is not taxed as it is covered by Tom's personal allowance.
The next £2,710 of gains is taxed at the 10% savings rate - so £271 of tax to pay. The remaining £13,185 of gains is taxed at the basic rate - tax of £2,637.
This means Tom's overall tax on income - or on receipts would be a more accurate term to use - is £3,208 when £300 of withholding tax on the OEICs is added in. That is an effective tax rate of just 3.2%.
Compared to an effective rate of 29.9% if it had all been annuity income.
Tom's strategy also has estate planning benefits. Because he is cashing in and spending investments that are subject to inheritance tax, rather raiding his pension fund - which is free from estate taxes until age 75.
From a pure estate planning point of view, the advice to clients could be ‘don't touch your pension fund until age 75 and live off your other investments until that time.'
They could then crystallise, make a gift of the PCLS and transfer surplus net retirement income into trust using the normal expenditure out of income exemption! Fanciful perhaps, and it would be good to find a client in such a position, but the theory is sound.
Some clients do not have a choice in how they fund their retirement income; they may be members of a final salary scheme perhaps. But for those clients who have private or personal arrangements, they could benefit from a decumulation strategy.
So make sure you emphasise to your pension clients that they should contact you before they crystallise benefits. Pre-retirement planning could save them a whole load of tax.
Achievements, charity work and other happy snippets
Appetite has suffered since Brexit vote
'Failure to pay attention can result in enforcement'
200,000 LISAs opened so far
From June 2019