A taxing emergency

Plenty of people have warned of the income tax implications of next month’s pension freedoms. As I wrote last year (How to spend it), someone drawing down £200,000 from a personal pension should expect to pay a minimum of almost £50,000 in income tax. That is even if they have no other taxable income. The Daily Telegraph has summarised this in a neat little table illustrating a number of different scenarios combining non pension income and the sum drawn down from your pension. The associated article can be read here.

The tax itself will be deducted at source by the pensions company and remitted to the Treasury.

Pension Tax

What is less widely noted though is that, in the absence of a clear indication of what your tax code actually is, pension companies will apply an emergency tax code. This could easily be as high as 45%. Worse still, it will ignore any entitlement you will most likely have to take 25% of the pot tax free.

The situation arises because HM Revenue & Customs treats any money drawn as the first of a series of monthly payments. This is similar to what currently happens when pensioners draw down a regular monthly sum from their pension to live on. It is less helpful for pension freedom withdrawals, which are likely to be one-offs and involve far larger sums.

The good news is that the money isn’t lost for all time. However, the process of reclaiming it is complicated and easily misunderstood. If you have no other income apart from your State pension, you must complete a P50 form and return it to HMRC. It will then take up to six weeks to receive your refund. If you do have other sources of income you must complete a P53 form.

Alternatively you can wait until the end of the tax year at which point the overpayment should be corrected automatically. The downside of being patient is that HMRC will be sitting on many thousands of pounds of your cash. To put this in monetary terms, if you take my example of a pensioner with no other income withdrawing £200,000, the overpayment could be anything up to £40,000. The true income tax liability is an already chunky £49,000. However, applying an “emergency” 45% rate and ignoring any 25% tax free cash entitlement, could easily see £90,000 of your £200,000 being remitted to HMRC.

Take care out there


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Speaking their language – managing student loans with pensions

The biggest hurdle to overcome when selling an idea to someone is to engage their interest.  Once the connection is made you ‘re off.  Now this can apply as much to personal conversations as it can to business or sales scenarios.  Equally though, there subjects or even words that are slam dunk conversation stoppers.  Thus I often try to contain my enthusiasm should a dinner table conversation with friends drift towards the vexed subject of pensions.

 So, after an excellent New Year’s Day lunch with old friends and their university-aged offspring, I was more than happy to listen to the students around the table describe their financial frustrations and challenges.  I manfully resisted the temptation to assume a financial mother hen persona.

The conversation continued to dwell on finances giving a rather fine bottle of red time to start to work its magic.  I chanced a one liner about ways of mitigating the burden of student loan repayment.  Encouraged by the fact that eyes didn’t glaze over immediately I elaborated briefly and will paraphrase below.

To put it simplistically student loan repayments are calculated as 9% of income above a certain threshold.  In 2014-15 that threshold is £16,910.  One way to manage this would be to somehow reduce your income.  I know that sounds a bit drastic, but bear with me.

In the case of child benefit HMRC starts to claw back benefit payments from any parent earning more than £50,000.  For someone earning a little above that threshold, one way of “reducing” their income, and by so doing retain more or even all of their benefit, would be to make pension contributions.  This works because the contributions are deducted from a person’s headline salary.

Unfortunately, student loan deductions are treated slightly differently inasmuch that from calculated before deducting tax or National Insurance contributions.

All is not lost, however.  A technique known as “salary sacrifice” can be employed to barter a portion of your salary for additional benefits (usually in the form of a pension).  This then does reduce your salary for the purposes of repaying a student loan.

Of course this might not be what you want to do and some people just want to repay the debt as soon as possible, which is fine.  However, salary sacrifice can be a useful tool for younger workers who want to make an early start on their pension provision.

One further consideration for those either approaching, or actually in retirement, is that the age cap on student loans was removed in 2013.  This, combined with an increase in the income limit from 2016 to £21,000, means that any pensioner undergraduate might never have to repay their loans if their pension doesn’t exceed the threshold.  Better still, after 2016, the threshold will rise in line with average earnings.

So whilst these are two slightly off the wall financial strategies, they don’t have to be conversation stoppers



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Taking a tax-efficient income in retirement

I’ve had a few conversations with people off line following my last post on the inheritance tax implications of #pensionfreedom.  What I’d like to do here is illustrate a few of the other implications in terms of how they affect different savings vehicles.  Before I do so however, it is important to note that Pensions Minister Steve Webb has stated that pensions should not become “a vehicle for inheritance tax planning”.  This suggests that it is at least possible that some of the recent pension freedom proposals might not actually see the light of day.  Worse still they might be reversed following May’s election.

So with that rather large pinch of salt, I’ll launch into what pension freedom, as currently proposed, implies for savings as I understand things to be.

To quickly recap, and generalise horribly, if you die after April 6th, but before the age of 75, your pension pot can be passed on to whomever you have nominated, free of inheritance tax.  Furthermore the pot will be theirs to spend as they please entirely free of income tax too.

Should you die after 75 the pot can still be passed on IHT-free, but tax will have to be paid at the recipient’s marginal rate if they require cash.  It is also worth remembering that the post 75 Death Tax reduces from 55% to 45% in April, but isn’t removed altogether until April 2016.

So how does this compare with other investments?  Recent ISA rule changes allow ISAs to be passed on between partners without losing their tax wrapper.  Previously ISA proceeds could be passed between couples, but, from the date of the first death, they would lose their income and capital gains tax advantages.  That new benefit is lost though on the second death and ISA assets become part of the couple’s estate for inheritance tax purposes, just like any other non-ISA savings.

So what we have effectively from the perspective of someone who has just retired is:

Private pension: Income is taxed at a person’s marginal rate and, if an annuity is not taken, 25% of the pot is generally available income tax free.  Zero IHT.

ISA: Zero income and capital gains tax.  Remember that assets can always be passed between partners free of inheritance tax regardless of tax wrapper.

Other assets outside ISA/Pension wrappers (bank deposits, investment funds, property etc): These generally enjoy no IHT exemptions and are subject to income and capital gains tax at the investor’s marginal rate.

These tax differences have implications for the order in which a pensioner might most efficiently derive an income from his or her savings, whilst maximising any possible legacy should their funds survive them.

All other things being equal it would make sense to utilise those resources deriving the least inheritance tax protection first.  It’s not quite that simple of course.  In certain circumstances it might make sense to combine income from non-wrapped and ISA sources in order to ensure that your marginal income tax rate is no higher than it needs to be.

Thus to cut a very long story short, the general idea would be to start to take your income from a combination of non tax-exempt assets, mixing in ISA income along the way.  This is because ISAs have income and capital gains tax advantages during a couple’s lifetime, which disappear entirely upon the second death.

The last port of call might be your pension (assuming you opt to drawdown rather than simply buy an annuity at retirement).  This is especially attractive to your loved ones due to the removal of the death tax.  It does highlight though the importance of making nominations of desired beneficiaries and, importantly, keeping these updated to reflect any changes in your personal circumstances.

This, of course, is all very simplistic, but does at least provide a few points to consider when deciding how to produce a retirement income from your assets.

So until everything changes yet again,

take care out there


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Spending the kids’ inheritance

I’ve already written about the direct income tax consequences of using 2015’s pension freedoms to draw down a private pension as a single lump sum.  To refresh, anyone opting to withdraw £200,000 as cash from their pension post 55 can expect to pay a minimum of £49,627 in income tax.  For sure you avoid the previous 55% rate, but you still end up paying as near 25% as makes no difference in income tax.

However, there are also more subtle tax implications to consider.

The most important relates to one of the freedoms that caught out virtually the entire pensions industry.  Not only were pension savings exempted from the penal exit taxes, but pension pots could also be passed on free of inheritance tax at death.  If you are unfortunate enough to die before the age of 75, but crucially after the pension freedoms are introduced next April, your entire pension fund can be passed on to your loved ones, or possibly even your spouse and children, entirely free of tax.  It doesn’t even need to be kept as a pension.  It will be a lump sum completely free of tax to be spent at the recipient’s absolute discretion.  Nice!

Even should you achieve the average life expectancy of 78.9 for a man or 82.7 for a woman, your pension pot can still be passed on intact. Any income drawn from the pot by the, hopefully suitably grateful, recipients would be subject to taxation at the recipient’s marginal rate.  However, it is relatively simple to organise your affairs to keep any drawn income within tax-efficient limits.

Many advisors and higher net worth individuals have been quick to appreciate the subtler estate planning implications of the proposed changes. In a nutshell, from next April, it looks like it will be possible to pass on a pension pot significantly in excess of the £1,250,000 lifetime limit with no inheritance tax payable and only a relatively small tax penalty on any sum exceeding that limit.  Effectively very large estates can be passed on from generation to generation, free of IHT, via accumulated pensions. If the recipients are prudent in drawing an income from this legacy, which they can do at any age, the sum will be largely kept intact for future generations. Richard Evans wrote an excellent piece on the possibilities of intergenerational pensions that effectively allow you to ignore the £1.25 million lifetime limit.

All this is very exciting if pensions and estate planning float your boat.  However, there are two important caveats.  The first is that the rules keep changing.  The second is that the freedoms could be reversed after May’s General Election.  My best guess though is that whoever wins will instead take the easy and sensible option of restricting tax relief on pensions contributions to the basic rate.

However, taking the freedoms at face value there are further implications.  If leaving a legacy is important to you, you should think long and hard about whether to drawdown a pension as cash.  I mentioned the income tax implications in my opening paragraph. However, as soon as money leaves your pension it also loses an important exemption from inheritance tax.

Consider the same £200,000 as used in the example above , which you might be earmarking for property investment.  After deducting the minimum of £49,627 of income tax, you are left with £150,373.  If you were to die with that sum still forming part of your estate (i.e. having invested it in the aforementioned property), it would attract a further 40% inheritance tax charge.  This, not unreasonably, assumes that your home and other assets already exhaust your £325,000 personal allowance.  This would leave just over £90,000 to be passed on upon your death, less than half the £200,000 that could have been inherited tax free had you left the pension as it was.

Getting back to the proposed changes, of course your first priority should be that you have enough money to live comfortably in retirement.  Indeed SKI-ing (or spending the kids’ inheritance) is precisely what many intend to do.  However, if you do have sufficient resources for your own needs, and it is important to you to leave a legacy, a crucial part of that planning might be the new IHT exemptions for private pensions.

Take care out there


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Pensions Freedom – the lessons from history

Fortunately it was the English who were dishing out the lessons against the Australians at Twickenham last Saturday. However, one lesson we would all do well to learn from Australia relates to the consequences of freeing pensions savers from the obligation to buy an annuity.

As the whinging poms stand on the verge of gaining some very significant pensions freedoms, the lessons of history should not be ignored. In 1993 Australia took a very similar step. More than 20-years later a root and branch examination of Australia’s financial system revealed some interesting statistics on how Australians have used their freedom.

The Murray Review, published in July, found that roughly half of those retiring in Australia take their pension as a lump sum. Of this group 44% used the money to pay off housing and other debts, to purchase a home or to make home improvements. A further 28% used the money to repay a vehicle or holiday loan or to buy a holiday or new car. The somewhat worrying result of all this is that a quarter of those who possibly regarded themselves as being reasonably well off at 55, had run out of cash by the time they were 70. The report also suggested that for some, even the mere knowledge that they were due a lump sum, caused them to overspend before they retired.

The inescapable conclusion is that a significant minority of people require more help than is currently available to rise to the challenge of providing for their retirement. It is an enormous step to go from living from month to month, or even week to week, to being given one lump sum and being expected to make it last for the rest of your life.

The need for financial education has never been greater.

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Annuities mis-sold shock!

Impaired annuities are very much in the news today. The Telegraph has made a front page splash of Aviva’s decision to pay compensation and increase payments after uncovering that hundreds of customers were sold inappropriate deals. At issue is that the company sold people standard annuities despite them being eligible for higher payments due to health issues or lifestyle choices.

The numbers vary considerably, but one major annuity broker highlights some possible income uplifts for impaired life products. If you’ve already suffered a stroke or had a heart attack, for example, you could easily be entitled to an annuity uplift of up to 75%. Even merely being a self-confessed smoker or overweight could increase your income by over 15% compared with the best standard products.

Anyway, the Telegraph article is well worth a read if you are considering buying an annuity. The lesson is, do check out the full range of annuity options and remember that up to 60% of annuity purchasers might qualify for enhanced income.

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How to spend it!

One of the biggest concerns I hear from people about retirement is how to turn pension savings into income.  When I were a lad there were final salary pensions for the lucky few with everyone else more or less compelled to acquire an annuity, if indeed they had any pension provision at all.

Whilst this wasn’t an especially flexible state of affairs, it did have the virtue of simplicity.  It meant that people didn’t need to think too deeply about their pensions if they didn’t want to.  For sure the financial outcome was often less than ideal, but the relative lack of interface with the financial system suited many people just fine.  Somewhat depressingly though, even as people were encouraged to shop around for the best annuity deal, as recently as 2010, a depressing two-thirds purchased their annuities from their existing pension provider.

Against that sort of backdrop it isn’t hard to imagine that the recently announced pension freedoms will actually cause some people considerable stress.  Previously the decision was largely taken out of your hands so there wasn’t quite the same scope to “regret” your choice once you were committed.

Next year, however, imminent retirees will be painfully aware that the path of least resistance, an annuity, is very likely not their best option.  At the same time though, they will be faced with the responsibility of how best to provide themselves with a pension for life from their savings: a weighty burden.

So what are the investment issues?

First up, the new freedoms change the investment horizon.  Previously someone just a year from retirement, and the associated annuity purchase, would be extremely risk averse.  They would be looking to protect their fund from an unfortunate, last minute slide in either investment valuations or annuity rates.  However, while an essentially zero return is fair enough over a few months, or even a year, the average length of retirement is already close to 20 years, which is an altogether different proposition.

This brings us to the second issue, that of investment returns.  With responsibility for the investment of what, even for those with relatively small pension pots, is still a large sum in nominal terms, zero returns over a period of two decades are both unconscionable and impractical.

The problem is that those with the smallest pots, and thus those in most need of strong investment returns, are precisely those who cannot afford the risk of a significant loss.  For them the attraction of a guaranteed annuity is likely to be proportionately greater, than for someone who is less risk averse.

For people with greater resources, and therefore more flexibility, the option to increase the weighting towards riskier assets increases pretty much exponentially. As alluded to above, this though brings with it the bewildering prospect of how to invest a considerable sum of money for both income and capital appreciation, which is the third issue.

In the past this was usually a fairly straightforward choice between bonds that pay a fixed, but generally low, coupon and equities which offer a variable, but potentially greater, return: or some combination of the two.

However, next year’s pension freedoms will significantly change things.  For a start, it will shortly be theoretically possible to withdraw your entire pension at 55 and invest it (or spend it) outside the traditional suite of pension products.  It is already possible to invest more liberally within a SIPP (self-invested personal pension) or a SSAS (small self-administered scheme), but there are still constraints and total withdrawal is currently a costly option from a tax perspective.

However, relieved of the punishing 55% tax exit fee, some people are intending to withdraw their entire pension pot next year and many appear intent on investing heavily in property.

Whilst I am hardly in a position to counsel against property as an investment, being a landlord myself, there are at least three serious issues that have to be considered first.

1) Tax.  While the 55% Death Tax or Pension Withdrawal Tax is set to be scrapped next year, pension income is nevertheless treated as taxable income, less the 25% tax-free cash sum if applicable.

Thus to withdraw £200,000 from a pension to fund a property investment, even assuming no other income is taken or earned in that year, will cost £49,627.

This is made up as follows:

£50,000 Tax Free Cash Sum

£10,000 Personal Allowance

£31,865 Taxed at the basic rate of 20%  £6,373

£108,135 Taxed at the higher rate of 40% £43,254

Grand Total  £49,627

This actually slightly understates the tax owing as, for simplicity’s sake, I have ignored the fact the the personal allowance is progressively withdrawn for those earning in excess of £100,000.

2) Illiquidity.  While property may yield an income, it is not certain (voids, costs etc) and your capital isn’t easily available for drawdown.

3) Returns.  Contrary to popular belief, buy-to-let investing isn’t generally a massively profitable undertaking.  If it were then many more developers would be building properties specifically to let, rather than selling them on to release their capital.  At the same time, the major source of property investment return for moms and pops is capital appreciation, not rental cash flow.  However, paper profits can only safely be realised by selling the property and, even then, you’ll very likely generate a capital gains tax liability.

The higher returns come from gearing, which is jargon for having a mortgage.  This not only makes your cash go further, but the mortgage interest is also tax deductible.  Someone investing purely for pension income though will very likely not have a mortgage, which will help in terms of cash-flow, but cuts the return on assets employment (i.e. your net rental income compared to your equity in the problem).  Either way though, investors will still need to do their own research to make sure the numbers stack up and that they have a viable business proposition.

I’ll revisit the subject of property as a pension investment in the near future as I know that many of you are interested.  More generally though you can see that the new pension freedoms present people with some very considerable challenges in areas which many have traditionally shied away from.  This is compounded by the advice gap I highlighted in an earlier post, whereby those with less than £250,000 of investable assets can sometimes find it difficult to get expert financial advice at any price.

Take care out there


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What pension are you entitled to from the State?

One of the important things you need to establish, even before you think about making additional savings for your retirement, is precisely what pension entitlements you already have. We looked at finding lost private sector schemes in an earlier post. Today I will show you how easy it is to find what you are currently entitled to from the State. Confusion is totally understandable as both the rules and retirement ages have changed numerous times in recent years leaving even some professionals in doubt.

Getting a state pension statement though is simplicity itself. The link below will take you straight there. Since the rules vary depending on age and sex, you have to answer a couple of simple questions. Some age groups will be able to obtain their statement online, others will be sent theirs by post after filling in a relatively brief form.


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Asset taxes revisited

Further to my earlier comment about a shift towards asset taxes, recent data show that receipts from residential stamp duty rose 31% in 2013-14 from the prior year to £6.5 billion. This indicates quite how important to the government taxes on assets are becoming in terms of revenue. This is especially true with income growth effectively flat-lining in real terms. Houses sold for £1 million or more generated almost £2 billion of that total.

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Lost & Found

Pensions advice is usually couched in terms of what you should be saving to ensure a comfortable retirement. However, it is equally important not to lose track of pensions entitlements already built up.

I’ll cover state and private pensions in a future update, but today I want to highlight a free government service that can help reunite people with pension entitlements built up with previous employers.

Strange as it may seem, it is easy to lose track of workplace pensions. Scheme administrators are notoriously poor at keeping even current employees informed, so ex-workers are easily overlooked or worse.

All is not lost though. The Pension Tracing Service keeps a register of workplace pension schemes, drawn from each scheme’s mandatory annual return.

The service can be accessed by telephone or by completing an online enquiry form .

The PTS is also happy to receive written requests for help.

You can call them on 0845 6002 537, complete the online enquiry form or write to them at:

Pension Tracing Service
The Pension Service
Tyneview Park
Whitley Road
Newcastle upon Tyne
NE98 1BA

They will require the name of your previous employer or pension scheme to get the ball rolling. However, the more information you can provide them with, the better the chance of success.

If you do visit their website it is well worth having a look round.  They have lots of useful pension resources, including what you can do if things go a bit wrong!


Take care out there



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