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Canada Life Article - How to navigate the taper caper

How to navigate the taper caper

 

With the introduction of the tapered annual allowance and the reduced lifetime allowance (LTA), retirement planning is somewhat limited for higher earners or those with generous final salary benefits, or well-funded self-invested personal pensions (Sipps), with no further scope to fund their pensions.

In considering employee remuneration, employers have found themselves left with the difficult dilemma of how to provide additional benefits. In particular, whether to pay additional bonuses or dividends, or continue funding contributions into a pension. For those employees with pension pots in excess of £1m who are intending to apply for Individual Protection 2016 and have their employer continue to contribute, it may still be the most tax-efficient option when compared to other forms of remuneration.

However, where the tapered annual allowance is causing the problem, this might not be so simple. Any payment made in excess of the reduced annual allowance would result in a tax charge on the individual at their highest marginal rate, regardless of the fact that it is the employer who has made the contribution. So, essentially, there is no tax relief on the excess over the annual allowance.

Though many of those restricted by the LTA may have large pension funds, those restricted by the tapered annual allowance may not have had time to build up sufficient retirement provision. It might be the case that their fund has significantly reduced as the result of a pension-sharing order and again due to the annual allowance restrictions, and they will find it difficult to rebuild pension benefits in what may be a very limited time frame.

So what are the alternatives to pensions, when retirement planning is the main concern or objective?

Bonds

One option is the international bond, which can be a useful pension alternative for providing additional retirement funds while having many complementary features that sit well alongside a pension as part of a retirement strategy.

• Regular premiums can be made to a bond.

• There is the benefit of gross roll-up within the bond.

• A tax-efficient income can be taken (within the 5 per cent limit).

• The bond can be wrapped within a trust for inheritance tax (IHT) purposes.

• The bond does not suffer from any restrictions in terms of annual or lifetime limits.

Obviously, there are other alternative investments to pensions other than international bonds, and it may be the case that the client has a combination of non-pension assets, all of which can play a part in producing tax-efficient income in retirement. So it does not have to be an ‘either/or’ scenario, and different products can complement each other.

Where there is still scope to contribute to a pension, even if at a tapered amount, it may be prudent to fund up to the limit and make use of any unused carry-forward from the previous three tax years. Some may find themselves in the fortunate position of having their employer make these contributions on their behalf, freeing up more of their personal capital to fund for additional retirement provision outside a pension, for example, into an international bond.

A mix of pensions and bonds close to and at retirement can, again, complement each other. As the bond has no age restrictions on withdrawals, it is possible to take tax-efficient payments (within the 5 per cent limit) before, say, the age of 55, to act as a bridging income until retirement or to supplement reduced wages. Then, once the pension becomes available, it is possible to phase income payments, so that only the tax-free cash is used, providing additional tax-free income.

In addition to pension and bonds, other investments can also be brought into the mix and advantage can be made of the various allowances now available, for example the new savings and dividend allowances.

Isas

Isas, unwrapped collectives, cash savings – indeed, any solution – can encompass a myriad of products/wrappers as part of a holistic solution.

Example: tax-efficient income

Victoria, aged 52

• Sold her marketing business (still does occasional consultancy work).

• Looking to supplement her ad hoc earnings for next three years.

• Looking to take a tax-efficient income from 55 onwards.

• She has an international investment bond, where the initial investment was £360,000.

• She has a Sipp worth £1.5m (with fixed protection 2014).

• She also has a portfolio of collectives and cash savings, some of which are wrapped into Isas.

Before age 55

• Victoria can take a regular withdrawal from the bond in the form of 5 per cent tax-deferred payments; and/or

• Take ad hoc withdrawals from the bond to supplement her consultancy earnings by making partial encashments using the accumulated 5 per cent tax-deferred facility.

From age 55

• She can take a tax-efficient income from her Sipp, phasing drawdown and using only tax-free cash to provide an income.

• Continue taking regular and/or ad hoc withdrawals from the international investment bond.

In those years with no consultancy earnings, she can take additional payments from either the pension drawdown or the international investment bond, keeping any income and realised gains within the personal allowance and still paying no income tax.

By utilising various income streams and making use of allowances, she could provide a tax-efficient income in retirement as the table below illustrates.

Wrapper
 
Income
 
Tax
 Sipp (crystallising £60,000 a year)
£15,000 (tax-free cash)
 None (tax-free)
 International investment bond (within 5% of original value)
£18,000
 None (tax-deferred)
 Consultancy - salary/earnings
£11,000 (earnings)
 None (within personal allowance)
 Collectives/discretionary fund management
£5,000 (dividends)
 None (within dividend allowance)
 Cash savings
£6,000 (interest)
 None (within starting rate band and personal savings allowance for basic-rate taxpayer)
 Total
£55,000
  

 

As you can see in this example, it is possible for Victoria to produce as much as £55,000 without an immediate income tax liability by making use of various products and tax allowances.

The Sipp could produce £15,000 tax-free cash for 25 years, assuming a fund value of £1.5m. The international investment bond could provide tax-deferred withdrawals of £18,000 for the next 20 years, based on an original investment of £360,000.

Even where there is no scope within the personal allowance or starting rate band to take other income completely tax-free, then providing it is within the basic-rate band, the £1,000 savings allowance will still apply. This reduces to £500 once higher-rate tax is payable.

By having a holistic investment strategy across all their investments they can use income producing funds with the bond; growth and income in the collectives; growth or guarantees within the pension; or indeed some other combination. Enterprise investment schemes or venture capital trusts could add further diversity to the mix, depending on the client’s overall tolerance to risk.

IHT

Although pension death benefits can in most cases be paid out free of IHT, international investment bonds can also be wrapped into trust to mitigate IHT.

The pension scheme can pay out a lump-sum death benefit or provide a beneficiary’s drawdown, both of which can be paid either tax-free or subject to income tax at the beneficiary’s marginal rate of tax, depending on whether the date of death of the member occurs before the age of 75 or on or after that age. Where greater discretion or control is required, setting up a bypass trust for those benefits may be a considered option.

It is also possible to wrap international investment bonds up within a trust to make them tax-efficient from an IHT perspective, as well as providing access to the capital while the individual is alive. This could be achieved by using a flexible reversionary trust, for example, to provide access to capital for the client, while having the option to assign or appoint polices to the beneficiaries, so that subsequent realised gains are taxed at their marginal rates.

There are other forms of trust – for example, a discounted gift trust, which can offer regular income payments where flexibility is not such an issue, or gift and loan trust, which can offer alternative forms of IHT-efficient solutions.

In conclusion, clients should still consider maximising pension contributions where possible, even if this is only within the reduced tapered annual limit each tax year, as well as making full use of the Isa allowances. Beyond that, international investment bonds can offer an alternative, with some of the features inherent in pensions. Clients can make regular premiums and benefit from gross roll-up within the bond. They also offer portability and similar investment options, such as unit-linked funds and access to platforms or discretionary fund managers (DFM). At retirement, clients can take tax-efficient withdrawals, which can complement other forms of retirement income, and have the ability to wrap their bonds up in trust as part of an IHT planning exercise.

Key Points

With the introduction of the tapered annual allowance and the reduced lifetime allowance, retirement planning is somewhat limited for higher earners.

A mix of pensions and bonds close to and at retirement can, again, complement each other.

It is also possible to wrap international investment bonds up within a trust to make them tax efficient from an IHT perspective.

 

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