All wrapped up?

Saturday, 01 October 2011
Article considering the impact of recent pension changes on high earners in the UK

The Finance Act 2011 ushered in even more changes to UK pension legislation. Pension simplification, much lauded in 2006, has withered and pretty much died under an avalanche of changes in the past few years. Quite understandably, many individuals looking to save towards their retirement are confused and concerned. In this state, people often prefer to do nothing, but if you want to have enough to live on when your income stops, you have to do something.

So, where are we now and what should we be doing? Well, the latest changes to pensions have brought some good news for those with earnings over GBP130,000 who expected their pension tax relief to be removed. They, like everyone else, will be able to contribute GBP50,000 each year and claim tax relief at their highest marginal rate. However, this is much less than the previous annual allowance of GBP255,000.

The significant reduction in the allowance may sometimes be offset by the newly introduced ability to carry forward unused allowances. An opportunity now exists to top up current-year contribution (as long as this year’s payment has been maximised) on the basis that the GBP50,000 allowance was not fully used in any of the previous three years. Failure to use carry-forward in a tax year will cause the earliest year of the three to fall away, so planning is important to ensure this ‘use it or lose it’ allowance is not missed.

Despite carry-forward, many individuals will be affected by the reduction in the annual allowance and will need to revise their pension plans to avoid overpaying or making tax-inefficient contributions. This is particularly significant for those higher earners in final salary pensions where this problem had never existed. Many may be unaware that their current pension accrual will be in excess of the annual allowance and that a tax charge is likely to be an unpleasant outcome. It will be well worth checking and, if necessary, renegotiating salary packages in a more tax-efficient manner.

With the low interest rates we are currently experiencing and little likelihood of significant increases in the near future, getting a suitable income in retirement is becoming increasingly difficult. It is also important to consider that, on average, we are living longer. This is, of course, good news but does mean that retirement pots need to last much longer than they did 20 or 30 years ago. Sadly, the answer can only be to save more, and for many, with pension contributions restricted, looking outside these arrangements will be the only option. What else is available?

Other retirement savings

The first port of call for many should perhaps be an ISA. The current limit of GBP10,680 pa doesn’t sound that much, but with regular contributions these can build to a sizeable retirement pot. While tax relief is not available on contributions, there is little tax paid within the investment fund and all withdrawals of capital and income are tax free in the hands of the investor. An income stream in retirement that is not taxed should never be ignored.

If ISAs have been maximised, another area to consider is investments that can achieve capital gains. Everyone has an annual capital gains tax allowance (currently GBP10,600) and this is probably the most under-used allowance in the UK. Building a portfolio over a period of years from which the individual can take gains of more than GBP10,000 each year without paying tax would give a great boost to anyone’s retirement plans. It will also be important to use the capital gains allowances as the portfolio grows, so regular planning is required with this type of investment.

If a portfolio has been built sufficiently to ensure that all allowances are fully used in each retirement year, some type of insurance-based investment contract could be considered. There needs to be a careful balance, as paying capital gains tax at current rates may be a better option. Certainly a level of caution needs to be taken with these, as the tax regulations are complex. Also, charges can be high, but if the investor is a higher-rate or additional-rate taxpayer when making contributions and will be a basic-rate taxpayer when encashing, these schemes can be effective. Again, careful planning is required when using this sort of investment wrapper, but if the planning is done well it is often possible to engineer a year or two when the individual is a basic-rate taxpayer in retirement, even when they would be paying higher-rate tax normally. As long as these investments are encashed at the right time then all is well.

Getting investments into the right wrappers is only half the battle

Think outside the box

Those with the right risk profiles could also consider some of the tax-led investments (venture capital trusts and enterprise investment schemes). These can offer a number of attractive tax breaks, but, because of the type of investments used, have a much higher element of risk. Anyone considering these investments should ensure that they take appropriate advice and be very clear as to the risks involved. That said, however, for the right individual, these can be very attractive.

When making plans, don’t forget that, if the client has an other half, they will also have their own allowances under all the different investment wrappers mentioned. It is often possible to double up on these allowances giving additional possibilities to build for a tax-efficient retirement.

A well-planned retirement should therefore see someone with investments in a number of different wrappers. This leads to options and opportunities in retirement where withdrawals can be taken from the most appropriate sources at any particular time. Using a combination of these wrappers will often allow the retiree to take substantial withdrawals while paying minimal amounts in tax.

Obviously, getting investments into the right wrappers is only half the battle. It is also vital to have the right investments in those wrappers that meet the risk profile of the individual and also look to give them the returns that they will need to achieve their goals. Unless someone has significant time to undertake research for their own benefit, getting the right advice is going to be important. This really has to incorporate the right level of diversification, ensuring that any unexpected negative movement in one asset class does not have an excessive effect on the overall investment. No one wants to have to postpone their retirement because of another Black Monday-type market crash.

New legislation looming

For those who are already well on the road to building a sizeable pension pot, there is another potential problem on the horizon. The lifetime allowance, which restricts the total amount that can be built up in a pension without it being subject to tax charges when the benefits are taken, is reducing from GBP1.8 million to GBP1.5 million at the start of the next tax year. For those with pensions valued at the current allowance, this could potentially cause a 55 per cent tax charge equating to GBP165,000.

Thankfully, the government has recognised that it would be unfair to those who have legitimately built pensions to this level and have therefore brought in what is known as fixed protection. This allows the individual to maintain the current allowance, but they will have to cease accruing any pension benefits after the end of this tax year. Any future accrual will cause the protection to be lost.

It is important, therefore, to check current pension levels to see if there will be a need to apply. As with the annual allowance, higher earners who are members of final salary schemes (who may also have additional voluntary contribution plans) may be affected by this change, so it is important to make sure that the value of scheme benefits is checked. Anyone needing protection will have to apply before the end of the tax year, so it is vital not to delay these checks. Early action will be especially important if, as with the issues around the reduced annual allowance, an individual has to leave the pension scheme. In those circumstances, it may again be necessary to renegotiate employment contracts to ensure future benefits are commensurate with what was lost through leaving the pension.

With the need to broaden wrappers used in retirement planning as a result of these new pension restrictions, consideration of the potential inheritance tax (IHT) implications associated with these alternatives becomes more relevant. A couple maximising their ISA allowances over a 20-year period could amass a combined fund well in excess of GBP500,000, potentially subject to IHT. This contrasts with pensions death benefits, which largely avoid being subject to IHT. So, as highlighted, we continue to be in times of change, but this can bring opportunity. The opportunities are, however, limited, so retirement plans should be reviewed sooner rather than later.

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Andrew James

Andrew James is an Advice Policy Manager at Towry, Bracknell.

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