This article discusses the effects of the reduction in the Lifetime Allowance and the alternative savings options other than your own pension.
It has been well documented that the fall in the standard lifetime allowance (LTA) applying to registered pension schemes may cause people issues in terms of what to do with their current and future pensions in terms of the on-going funding and fund size. Various forms of protection have been introduced, but what if these are not applicable or correct for the client? In addition to this, HMRC have also introduced restrictions on pension funding for high earners, which will taper the annual allowance down to a minimum level of £10,000 (2016/17 tax year). The purpose of these articles is to discuss pensions and other options available for people who may be affected by the reduced lifetime allowance. This will cover both the investment and income alternatives to pension funding.
In many ways, much as these potential reductions could create an issue, it can also highlight the need for holistic financial planning to be used in this fast changing financial and legislative environment.
This article is designed as an overview of what may be done and alternative options and is not designed to cover the full technical details. Other articles on Knowledge Direct which will have more in depth details of items discussed in this article.
In this second article we cover options available to the client. We lay out options and alternatives outside of the pension provisions that may wish to be considered. There are many Knowledge Direct articles which will go into more detail of the options, taxation and products mentioned.
We have so far in part 1 of this article discussed what to do within a pension. However, there may be potential opportunities to use other products to enhance the client’s future requirements in tax efficient ways. This is nothing new in terms of products but more of a reminder to how life products can be combined for retirement planning.
- Child/spouse/partners pension – By funding for a relative’s pension the client will get no immediate tax benefit. However, a spouse or partner will get tax relief at their marginal rate on the contribution that the client makes and the client will benefit from the additional income and tax free cash that this generates in retirement if this is done for a spouse or partner. This can help the couple plan their income requirements between them both to best facilitate tax planning. Any contributions made to the child’s pension will again not benefit the client directly for income tax relief as the contribution will receive tax relief at the child’s marginal rate but can be seen as planning for the child’s future and some form of estate planning if it can be argued that contributions being made come from normal expenditure out of income.
- ISA – It may be obvious to say that a client should use an ISA for tax efficient saving but this can also be beneficial when looking at income streams as well. Obviously we know that if the client is taking the unavailable pension contribution as income this will suffer income tax and national insurance. However, once this is paid into an ISA the fund will grow in a tax advantaged environment and there is no capital gains tax due on disposal. The maximum that can be paid in each year for anyone who is UK resident is £15,240 and rising to £20,000 in 2017, which may not be sufficient to cover a new increased salary in place of the unavailable pension contribution and may need to be considered with other forms of investment. It is possible to accrue significant funds over the years until the client’s retirement. This fund can then be used to produce income alongside the pension fund or possibly in place initially of the pension fund and so can be used to help regulate the tax situation of the client as this income will be tax free. This may be used to defer the pension income which will have the effect of, over that period of time, maintaining the pension fund in its tax advantaged status of death benefits being outside of the client’s estate for IHT. Other potential options are also being developed in the ISA market with the introduction of the Lifetime ISA proposed from 2017.
- Collectives – Collectives invest in unit trusts and OIECS. These assets will potentially create taxable income (and dividend income) within the funds and this will need to be considered by the client in their income tax returns. This gives the client the opportunity to use the £5,000 dividend allowance introduced in April 2016 and also use the personal savings allowance available. In addition, one of the primary reasons for unit trust is capital growth. The client can use this capital growth to disinvest elements of the investment over the years to act as additional “income” in place of the income a pension could provide, or to top up the pension income without creating further income tax or taking the client into a higher rate tax band. The only thing the client would need to consider is that the disinvestment they plan to use as additional funds (or 'income') will be restricted by their personal capital gains tax (CGT) allowance (£11,100 for tax year 2016/17). Remember this is the amount of the gain the client can make and not the amount they can disinvest and so this disinvestment could be a significant amount. As this is not classed as income and is within the CGT allowance this could provide a significant amount of capital for the client at no taxable cost. If additional funds are required it is also potentially possible to use inter spousal exemptions to transfer the ownership of assets from one spouse to another so they can use both client’s CGT allowances. See article: Savings and Dividend taxation bands and allowances
- Bonds – Bonds could be considered to be used alongside existing pension scheme to provide a stream of 'income' that could be taken with the advantage of being tax deferred. Under a bond up to 5% of the initial investment can be taken each year without the need for being taxed until the whole of the initial investment has been paid out. So for example a client could invest £100,000 and take 5% from this bond each policy year for 20 years and have no tax to pay at the time on these withdrawals. If the full 5% allowance is not used in one policy year this amount is not lost and can be carried forward to be used in a future year in addition to the 5% allowance available for that year. This income could be used either in conjunction with or to replace pension income for a period of time.
In addition if looking at offshore bonds there are added flexibilities that may need to be considered. For example an offshore bond will create a chargeable gain in the same way as an onshore bond. However, an offshore bonds gain is treated for tax under the savings income rules rather than being added at the top of the order that income is taxed. This means that the client can look at using their personal savings allowance to offset some or all of their income tax liability in these cases.
See article: Savings and Dividend taxation bands and allowances
- Reduce or phase the pension income being taken from capped drawdown to below the higher rate tax threshold and 'top-up' any additional income needed by utilising the 5% withdrawal allowable from the bond. As these are tax deferred withdrawals from the bond there is no tax to pay at this time and the client can continue as a basic rate tax payer.
- Crystallise the pension and take the tax free cash. Use this tax free cash to fund income requirements for the initial years and then use the 5% bond withdrawals (and the accrued 5% amounts not taken) for the next few years. This would then give the pension fund time to grow in a tax advantaged environment to produce a good level of income when benefits are finally taken. This has the added advantage of meaning the client can have a period of time using this method where they are not creating any income tax charge and possibly using this time to disinvest any assets creating a capital gain at the lower CGT rate. This scenario can also work if just using the bond and not crystallising the pension for the initial years. This would also have the added advantage of the pension fund being unvested and so before the age of 75, any death benefits would be paid free from tax to the beneficiaries (possibly spousal by-pass trust may be applicable).
All of the above options – or any combination – may be applicable to your client’s individual circumstances. In addition to these, income could also be used to fund for life cover and estate planning and in many cases trusts could be used in various forms for some of the investments. The purpose of this article is not to point you in any specific direction but rather the illustrate that there may be options that may be overlooked when dealing with what is initially an issue surrounding pension topics only.