Comment on recent FTAdvisor article on pension freedom

FT Advisor last week published an editorial about how Pension Freedom was “not working”.  In the comment section I ventured that Independent Financial Advisors might be leaving themselves vulnerable if they have a policy of always declining transfers from Defined Benefit (final salary) schemes into Defined Contribution arrangements, such as a SIPP.

Most people would be best advised to stick with their final salary pensions.  However, if leaving an inheritance is important to you, and, crucially, you have sufficient other resources from which to draw an income, a transfer could make sense.  This is because a defined contribution pension, in many circumstances, can be left to descendants free of inheritance tax and now, thanks to Pension Freedom, without paying the 55% Death Tax.

By systematically denying pension savers this opportunity, IFAs will almost certainly be giving their clients advice they know to not be in their client’s best interest.  See the article and my comments (stuarttrow) at



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The meek shall inherit the earth (if their parents are rich enough)

Until relatively recently the tide had been running very much against inheritance tax planning.  Successive governments had closed loopholes and negated time-honoured strategies to make what was once dubbed a “voluntary” tax more and more difficult to avoid.  Over the past year though those lacking the gift of immortality have been presented with two very valuable estate management tools.

The first I have already discussed at length.  Abolishing the so-called pensions “death tax” allows pension funds to be passed from generation to generation, only being taxed at the beneficiary’s marginal income tax rate when cash is withdrawn.  Technically a pension fund could always be passed on free of the reviled IHT.  The problem was that the so-called death tax (arguably the ultimate exit charge) of 55% more than made up for the IHT exemption.

Last week’s budget though added another tool to the estate planner’s armoury, namely the potential to shelter the family home from IHT.  Currently we all “enjoy”, although I’m not quite sure that is the correct verb, an IHT allowance of £325,000.  For a couple that sums to £650,000 with a relatively recent innovation being that that allowance can be passed on to the surviving partner upon the first partner’s death.  Thus, combined with the fact that trusts tend to be less favourably treated these days, the default option for many married couples is to leave everything to the surviving spouse who will then proceed to give away as much as possible once their own needs have been met (utilising gifting rules and seven year potentially exempt transfers).

What Mr Osborne added last week was a further IHT allowance per person specifically associated with the family home.  This will start at £100,000 in 2017 and steadily rise each year until it reaches £175,000 in 2020/21.  Thereafter it will rise in line with the Consumer Price Index.  When complete it will exempt a £1,000,000 family home entirely from IHT, although everything else will then be taxed at 40%.

The tax planning opportunity comes where people have more modest homes and are relatively cash rich.  Granted this doesn’t apply to everyone.  However, if you are looking to leave a little something to the kids or grandchildren, it might be worth considering “upsizing” the family home if that is an option.

Let’s put some figures on that.  A married couple with a home worth £650,000 could upsize (or at least upvalue) to a pad worth a million.  Think luxurious penthouse apartment with a stunning cityscape view!  This would potentially save their heirs £140,000 in inheritance tax by sheltering an additional £350,000 in the family home.

Those still looking to downsize will be able to do so by utilising another innovation, the “inheritance tax credit”.  This preserves the new allowance for those downsizing so long as the bulk of the estate is left to direct descendants.  The hope is that this will encourage retired individuals to free up larger houses for growing families.

It’s only fair to point out that once the family home reaches beyond £2,000,000, the additional allowance is withdrawn at the rate of £1 for every £2 of value.

Additionally you will not be surprised to hear that not only does the Chancellor giveth, but he also taketh away.  The cost of all this IHT largesse is that those earning more than £150,000 will see their annual pension contribution allowance stepped down in increments from £40,000 to £10,000.

The upshot though is that families now have two new and very powerful tools to shelter considerable funds for future generations: private pensions and the family home.  The caveat, of course, is that the law is so fluid that any beneficial change could easily be reversed with expensive consequences.  I suspect though that these two particular changes will be preserved going forward, even if future governments feel the need to temper pension freedoms generally going forward.

Take care out there



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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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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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