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TaxationWeb by Bob Fraser MBA MA FSFA

Pensions have had a bad press over the past few years, resulting in many people questioning their value. Bob Fraser, Associate Investment Director of Rensburg Investment Management Limited, offers the case that pensions still represent a tax efficient way to provide a future income in retirement, and re-states the tax planning case for pensions based on current tax legislation.Pensions have had a bad press over the past few years, resulting in many people questioning their value. Much of the criticism centres on occupational schemes. Investment conditions have also brought disillusionment (depending on asset allocation) as fund values in many sectors have fallen, although those continuing to invest regularly will have benefited from pound cost averaging.

However, pensions still offer a tax efficient way to provide a future income in retirement. The aim of this article, therefore, is to re-state the tax planning case for pensions.

The tax breaks for pensions are:

Tax relief on the contributions

For personal/stakeholder pension contributions this is granted by an immediate uplift of 22% on the contribution (i.e. £2,808 contributed becomes £3,600 invested), followed by a further 18% reclaimable through the tax return for higher rate tax payers. For occupational schemes the employee contribution is paid gross of their marginal rate of tax. Employer contributions are paid gross, and the employer treats the contribution as a trading expense.

Tax efficient investment

The fund is not liable to tax although dividends deriving from UK stocks are now taxed.

Tax free cash on taking benefits

Up to 25% of the personal/stakeholder pension funds can be taken as tax free cash when the time comes to take benefits. (The current rules for occupational pensions are different, but from 6th April 2006 the tax free cash level will be standardized at 25% (apart from transitional arrangements for those with an entitlement to a greater amount)

The income eventually taken from a pension is taxed at the pensioner’s marginal rate of tax. So a high rate tax payer who gets 40% tax relief on his contributions, and then becomes a basic rate payer in retirement paying 22% income tax, effectively benefits from an 18% tax difference.

Maximising use of personal allowances

Few people consider the benefits of pensioning their spouse. There are, however, some significant advantages to be had:

1. Tax relief on the contribution. This is available at 22% even if the spouse is not in employment and pays no tax. The government permits net contributions of up to £234 per month (£2,808pa) to be made for/by any individual under the age of 75 provided that they are not in an occupational pension scheme and earning more than £30,000pa (and are not a controlling director). This includes children, low-earners, and the non/unemployed.

2. Tax efficient roll-up.

3. 25% of the fund tax free on retirement.

4. As stated above, income from a pension is taxed at the pensioner’s marginal rate. However, if this income is contained within the individual’s personal allowance, it will be tax free. Based on a 6% annuity rate this would allow a fund of £79,000 after 25% tax free cash (£105,300 before the tax free cash).

5. If the spouse’s total pension funds are less than £15,000 after April 06, then (s)he will be able to take 25% of it as tax free cash, and the balance as a lump sum after tax at the marginal rate.

The above scenario is even more tax efficient for a self-employed husband/wife (40% tax payer) who employs his/her spouse. As long as an income is paid, (s)he can then pay £3,600pa gross into a stakeholder pension plan for the spouse, and claim tax relief on it as a business expense.

Equalising basic tax bands

Many individuals have accumulated large pension pots to secure their retirement. Few, however, plan for tax in retirement. A married individual with a retirement pension income of £40,000 will pay £8,147 in income tax (assuming no other income). However, had (s)he ensured that his/her spouse had pension funds to provide £5,000 of that income, the total tax payable (assuming the spouse had no other income) would be £6,438, a saving of £1,709. The aim, clearly, is to try to ensure that pension income does not creep into the higher tax band if it is possible to use a spouse’s basic rate band first. The reason is to try to avoid “balancing” the tax reliefs. Obtaining 40% tax relief on contributions followed by 40% income tax on the proceeds is much less advantageous than 40% tax relief on contributions followed by 22% income tax on the proceeds.

Using the tax free cash

Many individuals have plans for using the tax free cash – for example to reduce a mortgage or to pay for a luxury. However, some people wish to use it to boost their pension income. Leaving it in the pension pot, though, is not tax efficient. Those who wish to increase their annuity payments by using the tax free cash would generally be better advised to take the tax free lump sum and to invest it in a “purchased life annuity”. This can provide an income in exactly the same way as a pension annuity, but with the difference that part of the income is treated as a “return of capital” and thus not taxed at all. Furthermore, the taxable part of the income is taxed at 20% for a basic rate tax payer, rather than 22% from a pension annuity. As purchased life annuities are usually only bought by those in good health, the annuity rates can be lower than pension annuities (particularly when comparing against impaired life pension annuities) so it is always advisable to compare the net returns from each just to confirm that the benefit exists.

It’s never too soon to start

As mentioned above, children are also eligible to have pension contributions made in their name. With all the adverse media coverage about future financial security in old age, many individuals are now funding pensions for their young children or grandchildren. It is sobering to reflect that if a child had £2,808 net pa invested for him/her (£3,600 gross) for their first 18 years, then assuming 7% annual growth that child could have a pension fund at age 55 of nearly £1 million. The total outlay would only have been £50,544. Even if the real rate of return is only 3.5% (i.e. assuming inflation of 3.5%), the buying power of those contributions in today’s terms when they reach age 55 could be £500,000. Furthermore, the gift of the pension contributions could be effective for inheritance tax planning, since the annual amount of £2,808 falls within the £3,000 annual gift allowance. This would then represent a total tax saving of 53.2% (40% IHT and 22% income tax), irrespective of any investment growth. There are also other ways to derive an IHT benefit from these contributions.

The End Game

A common complaint about pensions is that ultimately (by age 75) the pension pot has to be used to buy an annuity. This generally matters more to those with large pension plans and for whom their pension income is only a part of their total income in retirement. These people often object to the fact that on their death (and that of a surviving spouse if there is a joint life annuity) the residual fund is lost to their estate.

The good news for such individuals is that the new pension reforms effective from April 2006 will introduce “Alternatively Secured Pension”. This is essentially a restricted type of “income drawdown” for those over the age of 75. The main benefit, however, is that on the death of the pensioner, or any surviving spouse or dependant, the residual fund could be paid to the pension plans of other members of the pension “scheme”. Such “schemes” will be able to be established to include other family members such as children. This should help to make pension planning more attractive, although it must be said that the Capital Taxes Office is looking at any possible IHT implications.

…And Finally

It is still possible to make personal contributions to personal/stakeholder pension and to have them treated as if made in the 2003/04 tax year. However, the absolute deadline for the pension provider to receive the completed documentation and payment is 31st January 2005. The actual 'carrying back' exercise is simple. You simply elect to have the contribution treated as if it was paid in the 2003/2004 tax year by completing the Inland Revenue form PP43(CB) and enclosing this with your pension application. This pension contribution then automatically receives basic-rate tax relief of 22%. Higher-rate tax payers can claim even more tax relief through their tax return. Higher-rate tax payers subject to self assessment can also use carry back to reduce any balancing tax payment due on January 31st 2005.

Conclusion

Pensions still have an important and tax-efficient role to play in retirement planning. Clearly tax should not be the only reason for any investment, and proper independent financial advice should always be obtained to confirm the suitability of any proposed course of action.


Bob Fraser, MBA, MA, FSFA
Associate Investment Director
Rensburg Investment Management Limited

February 2005

Contact Bob Fraser

Bob Fraser is an associate investment director and has achieved the highest level of professional advisory qualifications in the financial services industry. He is a Fellow by examination of Personal Finance Society, which is a specialist faculty of the Chartered Insurance Institute. He also holds a Masters of Business Administration degree.

Rensburg Investment Management is the largest company in the Rensburg group and a subsidiary of Rensburg plc, a public company whose shares are quoted on the London Stock Exchange. Its core business is investment management and it currently looks after around £3.0bn of funds for private investors, trustees, charities and pension funds. It provides independent financial planning advice and investment management services to both individuals and businesses in order to meet their financial objectives. Financial planning is the process by which resources and risks are firstly identified and then used or provided for in a way which best achieves financial goals and lifestyle. It provides detailed advice to clients across the whole range of financial planning issues from the provision of straightforward life assurance, to savings and retirement planning, to complex inheritance tax planning arrangements.

Rensburg is authorised and regulated by the Financial Services Authority (FSA) whose function is to provide investor protection through the regulation of financial product providers in securities and derivatives business.

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