TAX ANGLES ON PENSION CHANGES
The Chancellor announced in the 2014 budget that the requirement to purchase an annuity to access pension funds was to be abolished from 6th April 2015.
This provides a number of tax planning opportunities for those over 50 who are still working, particular those over 55 with above average earnings.
It is perhaps best to look at what the rules are now and then how they are set to change.
Briefly, at present an individual can access his pension pot at any time from age 55. He can draw 25% of the fund as a tax free lump sum and with the remainder he must purchase an annuity which will provide him with a taxable income for the rest of his life. The exception is if he has already secured pension income of at least £12,000 per annum (from a state pension, occupational pension and other personal pensions). In this case he may opt for flexible drawdown. Under flexible drawdown he can withdraw sums at will from his fund paying tax at his marginal rate on all such withdrawals in excess of 25% tax free cash.
Under the new rules flexible drawdown is available to all. In effect the minimum secured income level of £12,000 is dropping to nil.
So, let’s look at some tax planning opportunities with a few fictitious examples:-
Andrew who will be 55 in May 2015, is an architect employed on a salary of £70,000 per annum, with investment income, £30,000 of his income is taxed at 40%. Andrew has £24,000 of accessible savings.
Andrew can invest £30,000 gross in a personal pension plan. Because he will pay net of 20% tax he will actually pay £24,000. When he files his self assessment return he will get a further £6,000 repayment so his net cost is £18,000. After his 55th birthday, Andrew can take the benefits of this scheme. Assuming no growth he will get 25% or £7,500 as a tax free lump sum and the balance taxed at 40%, or £13,500 net. So when he replenishes his original £24,000 savings with the tax rebate (£6,000), the tax free lump sum (£7,500) and the taxed payment (£13,500) he now has £27,000, a 12.5% return in less than a year.
Barbara, a solicitor has an income of £120,000 and £32,000 of accessible savings. She intends to retire at the end of March 2015 when she is 60 and expects to receive a lump sum of £90,000 and a pension of £30,000 per annum from her occupational scheme. Barbara intends to use the pension lump sum to pay off her mortgage, and her savings to supplement her income until her state pension commences in a further 6 years.
Barbara can make gross pension investments of £20,000 now and again in the 2015/16 tax year. She will contribute net of 20% tax and so her payments of £16,000 for each year will exhaust her savings. The contributions will reduce her taxable income to £100,000 for each year and she will get back her personal allowances which together with tax relief will mean her total tax reduction over the two years will be £16,000. So she has got back half of her savings and has £40,000 invested in a pension plan. Assuming no growth, Barbara can, in April 2016, draw £10,000 tax free to add to her savings. She can then draw the remaining fund as taxable income of £5,000 per year for the 6 years until she starts to draw her state pension. That £5,000 per annum will be taxed at 20% and so she will actually receive £4,000 per annum net leaving her a shortfall of £1,333 when compared to her original plan to exhaust her savings over that 6 year period. But because of the tax relief and the tax free lump sum, she starts this 6 year period with £26,000 of savings. If she spends £1,333 per annum from this she will still have £18,000 left when she starts to draw her state pension.
Craig, aged 50, is an IT Contractor and he derives his income from his own limited company. The work Craig carries out for his client is very much akin to employment and his is caught by legislation known as IR35 which means that almost all of the money his company generates is paid to him as salary together with PAYE and NI deductions. Craig has estimated that the gross salary he will get from his company is likely to be £120,000 per annum. Craig has a small pension pot from when he was a permanent employee (of his now client). Craig recognizes that he will need to work until the state retirement age of 66 and is acutely aware of the fact that his mortgage is set to run until he is 70. At age 66 he will still owe about £40,000. Craig pays school fees for his 10 year old twin sons and from his net income only manages to save £10,000 per annum.
Despite being caught by IR35, Craig can reduce his salary if his company makes a pension contribution. Ideally he should reduce his salary to £100,000 by making pension contributions. Because a reduced salary will also mean reduced employers National Insurance, a total of £22,760 per annum can be contributed. Because Craig’s personal allowances are restored, his net salary after tax and National Insurance only reduces by £7,600 despite a gross salary reduction of £20,000, so he can still save £2,400 per annum.
By the time he is 66 and assuming no growth, his savings will be £38,400 rather than £160,000, but still about enough to fully pay off his mortgage. However, again assuming no growth, he will have accumulated a pension fund of £364,160(i.e 16 yrs x £22,760). He could take tax free cash of £91,040. The remainder could be drawn out over a number of years at such a level that it would only be taxed at 20%. This would give Craig further total net income of £218,496 (i.e £364,160 less £91,040 x 80%), and in a far better position then he would have been in without a pension plan, even without any growth.
A few words of caution are necessary. Anyone considering pension planning along these lines should take professional advice. Tax efficient contributions are limited to £40,000 per annum and there is an overall pension cap of £1.25m.
There is an anti-avoidance legislation to tax re-cycled tax free lump sums where they are greater than £12,500 and further anti-avoidance legislation may be introduced before the changes referred to in this article take effect on 6th April 2015.
This article is not intended to be and does not constitute financial advice or any other advice, is general in nature and not specific to you. Before using the above information to make an investment decision, you should seek the advice of a qualified and registered financial adviser and undertake your own due diligence.