The pension landscape has changed dramatically over the last few years, prompting many enquiries from both clients and their legal advisers. With changes to the annual and lifetime allowances, as well as the Inheritance Tax treatment of pensions, in this article we look at a number of challenges and opportunities which must be considered when planning for a financially independent future.
Making full use of the annual allowance
Firstly, the annual allowance is the maximum that can be contributed into a pension across the tax year – it is currently £40,000 (although you cannot contribute more than your annual earnings). For higher earners, this level is tapered and reduces to a minimum of £10,000 for people with more than £210,000 of income. If the annual allowance has not been used up in the previous three tax years, it could potentially be carried forward once the current year’s annual allowance has been used.
For those with final salary pensions, calculating the level of contribution is complex which can sometimes mean those with long service or changes to circumstances (such as a promotion) can suddenly find themselves with an unexpected tax charge.
There can also be issues for those who cannot accurately predict their income for a given year such as Partners. Attempting to maximise pension contributions can become like trying to hit a moving target!
Avoiding a lifetime allowance tax charge
The lifetime allowance is the maximum that can be accumulated in pension savings before a tax charge arises. This limit is now £1.03 million after increasing by CPI inflation in April 2018, but has otherwise been subject to a number of reductions since its introduction in 2006.
There are forms of protection available for those caught by the previous reductions. It is not uncommon to come across clients who have not realised they have an issue with this until it is nearly too late to take action. For example, someone with a final salary scheme paying little more than £50,000 per year could have an issue.
Often, the first reaction of a client will be to do everything they can to avoid the tax charge arising – this can be up to 55% of the excess depending on how the benefits are structured. However, this may not always be the most effective strategy since, depending on their wider circumstances there could be the possibility of minimising other taxes, most notably Inheritance Tax.
Opportunities to save Inheritance Tax
One of the opportunities presented by recent changes to pension legislation is to consider which assets should be used first to provide an income. A pension fund will now normally pass on free from Inheritance Tax, so using other assets first can be an effective means of mitigating the effects of tax on the estate.
Other options for taking a tax-efficient income
Once upon a time, the default position might have been to buy an annuity to generate a guaranteed income for life, which could have been index-linked and would provide a high level of long-term security.
However, there is now a myriad of options for generating income tax-efficiently by careful use of the available tax allowances. Arranging assets in a broad-based manner provides the widest range of options when it comes to retirement. Many clients will be attracted to property as an asset as part of such a strategy, but maintaining the right level of liquidity is also important.
Careful planning can allow you to make the most of your personal allowance, savings and dividend allowances and Capital Gains Tax annual exemption to name a few. Alongside these, ISA portfolios provide tax-free access to income and capital and there might also be a case for using tax-deferred withdrawals from investment bonds.
With all the planning in the world, it is still important to ensure that the underlying investment strategy remains appropriate, so that the right balance is achieved depending on when different assets may need to be accessed in the future.
Advice is essential
For all of these reasons, getting the right advice is critical to secure future financial independence with the least tax impact possible. To find out how a financial planner could help you or your clients, please contact Nick Geere on 01223 452863 or firstname.lastname@example.org.
The value of an investment may go down as well as up, and you may get back less than you originally invested.
This article does not constitute personal advice.