Pension planning can be complicated but there are ways to mitigate tax and maximise potential growth for your clients' retirement pots.
1. Make use of allowances and pension contributions to reduce tax
The annual allowance for pension contributions has shrunk over the past decade. The focus in the last few years has been to restrict higher rate relief for high earners. For example:
- Child benefit tax when either parent has net adjusted income (NAI) over £50,000 a year is levied to effectively reduce benefit. Benefit is lost completely when income reaches £60,000.
- Reduction of personal allowance where NAI is over £100,000 a year, resulting in a loss of allowance when income reaches £123,000.
- The Tapered Annual Allowance (TAA) is designed to reduce the annual allowance when an individual’s adjusted income is over £150,000. The Allowance is reduced to £10,000 when adjusted income reaches £210,000. Adjusted income includes all taxable income, employer and personal contributions (when applied under a net pay arrangement).
- However, where “Threshold Income” - taxable income less specific deductions such as a personal pension contribution does not exceed £110,000, the TAA will not apply.
Personal Pension contributions can, potentially in these circumstances, avoid punitive reductions to allowances, including child benefit and the personal allowance.
Even when the TAA applies, by using carry forward, unused allowance from the three previous tax years can be used.
A contribution of £130,000 is possible - a £10,000 contribution for the current year plus £120,000 (three x £40,000), assuming no contributions have been made in the last three tax years.
The contribution can come from an employer or if sufficient earnings from the individual.
2. Consider taking withdrawals from drawdown prior to the second Lifetime Allowance test (BCE 5a) at age 75.
It may seem unfair to reapply the Lifetime allowance (LTA) test at 75 when the funds have already been tested at designation stage (BCE1). However, it is only the investment growth that is retested.
Excess growth is charged at either 55 per cent if taken as a lump sum (must be before age 75) or 25 per cent if taken as income which is then subject to income tax at marginal rate.
For example: A client aged 74 has a drawdown fund valued at £1.1m.
- In the 2009/10 tax year (LTA was £1.5m), £750,000 was designated to drawdown after tax free cash (TFC) was taken.
- This used 66.66 per cent of the LTA applying at the time, leaving 33.34 per cent. (£750,000 + TFC of £250,000 / £1,500,000)
- £1,100,000 - £750,000 (the designated amount in 2009) = £350,000 investment growth.
- £350,000 - unused LTA of 33.34 per cent of £1m (the current LTA) = £333,400 = £16,600
- Excess is £16,600.
- If the client makes £16,600 withdrawals before the test BCE5a is applied at age 75 there will be no excess and so no charge. Assuming the client is a basic rate tax payer, income tax of £3,320 applies.
- If no withdrawals were made a LTA excess charge would apply (£16,600 x 25 per cent) = £4,150 plus.
- Income tax on income of £12,450 (£16,600 - £4,150) x 20 per cent = £2,490.
- This equates to a tax saving of £3,320.
3. Where possible take main source of income from tax-free cash.
The phasing of TFC is becoming the new default option for many individuals looking to minimise income tax and maximising their TFC entitlement.
By phasing benefits, the remaining uncrystallised funds continue to benefit from any investment growth with 25 per cent tax-free.
When the client is under the age of 75, it seldom makes financial sense to take TFC (assuming no capital requirement) as TFC once taken cannot be invested as tax efficiently outside a pension wrapper.
However, leaving the TFC uncrystallised post age 75 will mean the tax free element is effectively lost if the member dies.
4. Consider using non-taxable sources for income such as ISAs /collectives, before making withdrawals from pension drawdown.
Pension wrappers are extremely tax efficient with tax relief on contributions and investment growth is tax-free. Even after the members death the remaining funds can pass to a beneficiary and continue to grow in this tax-privileged environment.
A significant proportion of clients will also hold ISAs, share portfolios / collectives and or deposits /bank accounts. These may be better income sources if the objective is to minimise tax.
By using specific investment allowances, as shown below for a basic rate tax payer, taxable income taken from a pension drawdown can be avoided or kept to a minimum.
5. Consider taking income from sources other than pension drawdown when markets are falling.
Drawing down income from funds that are impacted by rising interest rates, inflation or simply a global downturn is a factor that impacts most individuals relying on a specific level of income.