From pensions to inheritance tax, venture capital trusts (VCTs) to Individual Savings Accounts (ISAs), there are a variety of methods to arrange your financial affairs tax-efficiently and at the same time reduce your tax burden, be it on your income or capital. Furthermore, analysing both how your investments are taxed and the product “wrappers” that you use, are equally as important in your tax planning strategy.
Given the changes to pension legislation over recent years, we will focus on the use of pensions in tax planning and their relevance in today’s environment.
Pensions
The tax reliefs successive governments have given to pension arrangements mean that they have long played an important role in tax planning.
The use of pensions in tax planning is often divided into two areas: pre-retirement and at-retirement. In practice, such a demarcation is an over-simplification because there is no longer any link between physical retirement – stopping work – and drawing on a pension arrangement. You may draw benefits, notably tax-free lump sums, before stopping work and make pension contributions after your working life has ended. In any event, the move between work and retirement is itself often a transition phased over several years rather than a one-off event.
Pensions can also play an important role in combatting another tax which may concern you and your family: inheritance tax.
Pre-retirement planning
Your personal contributions to a pension normally qualify for income tax relief at your highest marginal rate(s).
If you are a basic rate tax payer, the taxman usually tops up your payment with tax relief at 20 per cent and if you are a higher or additional rate taxpayer you can claim further relief at 20 per cent or 25 per cent through your tax return. Your employer can also make contributions to your pension. These contributions reduce your taxable income and, as such, the amount of National Insurance contributions paid.
As pension contributions reduce your taxable income, it could help you to mitigate the phasing out of the personal allowance, which “bites” at £100,000 of taxable income and results in an effective tax rate of up to 60 per cent. Contributions could also help you to sidestep the additional rate tax band, which starts at £150,000 of taxable income. Within a pension plan there is no UK liability to tax on income or gains and normally up to 25 per cent of the accumulated fund can be drawn as a lump sum, free of any tax.
The rules on the maximum contributions that qualify for tax relief are complex, have changed significantly, and are in the process of being altered yet again. Very broadly speaking, there is an overall ceiling (the annual allowance) each tax year for contributions (actual or deemed) from all sources. For the current tax year (2013/14) the annual allowance is £50,000, but from April 2014, it will be cut to £40,000. If you exceed the allowance, you may still be able to obtain full tax relief if total contributions have been under the annual allowance in any of the three tax years immediately preceding the current tax year, provided you were a member of a registered pension scheme. For example, in the current tax year, you could exploit unused relief dating back to 2010/11.
In theory, the carry forward of unused allowances and the complex rules for matching pension contributions to tax years mean that it could be possible to make up to £240,000 of pension contributions in 2013/14 with full tax relief. However, both the calculation of unused relief and the identification of contributions to tax years can be far from straightforward and, if this type of planning is appropriate, you should seek professional advice.
Child Benefit
In addition to our own pension planning, you should also consider how income can affect benefits perceived to be automatic and regular, and how you can use pensions to protect these.
One area is child benefit, where a new charge (known as the High Income Child Benefit charge) has been imposed on a taxpayer who has an “adjusted net income” of over £50,000 in a tax year, where either they, or their partner, are in receipt of Child Benefit. This charge is collected through self-assessment.
If both partners have an “adjusted net income” of over £50,000, the partner with the higher income is liable for the charge. You must register for self-assessment by 5 October 2013 for the 2012/13 tax year. If you miss this deadline you may incur a penalty charge.
HMRC will shortly start sending letters to higher rate tax paying households reminding them that if their income is over £50,000, and they or their partner received Child Benefit in 2012/2013, they will be subject to the High Income Child Benefit charge.
However, careful pension contribution planning may enable you to protect the Child Benefit from this charge. For example, if you earn £55,000 and make a £5,000 pension contribution, this would reduce your “net adjusted income” to £50,000 and therefore the High Income Child Benefit charge would not apply. In addition, you will have more money saved for when you retire.
Pension Contributions for Children
As well as managing our own retirement, we can also consider that of our children, as those born today are unlikely to enjoy the same level of retirement income that baby boomer generation are currently enjoying.
Our children will need to be more self-sufficient as State support is likely to fall, and company perks such as final salary pension schemes continue to rapidly disappear.
From the moment a child is born, they are eligible to receive contributions of up to £3,600 into a pension each year and anyone can make those contributions on behalf of the child. The person making the contribution would only need to pay £2880, and the tax man would top up to the maximum eligible amount of £3,600. Such “up front” tax relief is not available on other savings plans such as a junior ISA.
Lifetime allowance
Alongside the annual allowance, there is also a lifetime allowance (LTA), which effectively sets a tax-efficient ceiling on the total value of your pension benefits. In 2012/13, the LTA was cut from £1.8m to £1.5m and it will fall by another 20 per cent to £1.25m on 6 April 2014. The forthcoming reduction will be accompanied by the introduction of two new transitional reliefs. If you think these reliefs may be relevant to you, an early review of your situation is vital to determine whether to register for protection. The decision is not clear cut, because opting for protection will generally mean stopping pension contributions.
At-retirement planning
The first decision at retirement is usually whether to draw a lump sum and an income, or just an income. Drawing the maximum cash may appear to be the right choice because the lump sum is currently tax-free, whereas any income is taxable as “earned income”. However, income can be a better deal if you are a member of a final salary pension scheme and you have to exchange (technically, “commute”) pension for cash. The decision depends on a variety of factors, including the rate at which pension is converted to lump sum, your need for capital and your state of health. Pension income does not come cheap: at age 65, £100 a month gross of non-increasing pension would currently cost about £22,000 to buy in the annuity market.
If your pension arrangement is money purchase rather than final salary, then maximising the lump sum will usually be the right move, but that does not necessarily mean drawing all of the lump sum at once. How you deal with the rest of your fund is a more complex issue.
• From a pure tax planning viewpoint, income drawdown – drawing payments directly from your fund – will often be attractive, because it gives you some flexibility to tailor your pension income to your requirements and tax position from time to time, and remaining assets continue to be invested in the stock market. A drawdown approach can also help in your estate planning, as any residual fund on death can usually be passed to your chosen beneficiaries as a lump sum, subject to a single 55 per cent tax charge.
• From an income security viewpoint, buying a traditional annuity removes the investment risk and potential unwanted reductions in income that are a consequence of choosing income drawdown. However, annuity death benefits are generally less attractive, especially once any guarantee period has expired, and there will be no scope to vary income each year for tax purposes.
The optimum structure for retirement benefits is best chosen in the run-up to retirement, but the flexibility available underlines the fact that a retirement income is now much more than just a fixed annuity.
Before taking any benefits, you should always explore your options.
Getting your pension planning right
Some aspects of the tax rules for pensions will typically change each year. This year’s Finance Bill contains more than its fair share because of the reductions to the lifetime and annual allowances. The regularity of pension tax revisions – not always detrimental – make it essential that your pension planning is reviewed at least annually.
Such an assessment can determine whether your existing pension strategies remain appropriate in your particular circumstances and consider the opportunities and pitfalls created by any legislative changes or market developments.
Chris Wise is a chartered financial planner and investment director at Hertfordshire-based Gemmell Financial Services. He is also a member of FE’s AFI panel of independent financial professionals.