Adrian Boulding: Guiding clients through the complex pensions tax web
Minimising pensions tax payments in decumulation is becoming more onerous for advisers, warns Adrian Boulding, as multi-layered thresholds are catching out more retirees
The limitation of the Lifetime Allowance (LTA) has been attracting a great deal of negative market attention in the last few weeks – especially from Royal London’s director of policy Sir Steve Webb and AgeWage CEO Henry Tapper. The insurer’s recent study found that 290,000 pension savers approaching retirement had already breached the current £1.03m LTA level and many of them were still paying in.
Royal London concluded the regime was already catching a goodly number of long-service public sector workers with DB pensions as well as lots in the private sector with salaries tending to range from £60,000 to £90,000. So, it is already hitting the mass affluent, not just the top earners.
One of the problems is that the LTA has been one of the most volatile of a patchwork quilt of pensions tax changes that together are bound to increase advisers’ workload to find ways of keeping tax bills down.
Introduced back in 2006 with a £1.5m starting point, the LTA has been as high as £1.8m and as low as £1m, making planning difficult for advisers and clients alike. For next year (2019/20) it will be £1.055m. The additional tax charges on those exceeding the LTA now raise more than £100m a year for the Treasury.
That means the Treasury’s take has increased by more than 1,000% in just 12 years.
For those exceeding the limit it can apply in either of two ways or a combination of both depending on how the excess benefits are taken – the charge is: 25% of any income taken, and 55% if taken as a lump sum.
In the absence of scrapping the LTA – which many are calling for – employers and advisers may need to consider recommending long-term saving in ISAs for younger people, at least in their first few years. If you are going to run out of pensions allowance, it would be better to forego contributions relievable at 20% when younger, than contributions relievable at 40% when older. The LISA may be particularly attractive for younger people looking to save to buy their first home.
And what about older workers who have already saved close to their LTA limit when they join the company? For the one in five retirement-age people in the UK still working – many of whom stopped work and then ‘un-retired’ later – employers may need to offer an income uplift or other employee benefits instead of an auto-enrolment pension, which employers currently have to offer all staff. Many older workers are already demanding money instead of pension contributions and this will become a bigger problem if the LTA remains at current levels.
LTA aside, then, what else has changed and what other potential pension tax traps are out there for your clients?
No new capped drawdown arrangements have been allowed since 6 April 2015. In these legacy arrangements, the amount you can take as income is capped at 150% of the income a healthy person of the same age, based on GAD rates, could obtain from a lifetime annuity.
Capped arrangements must be reviewed every three years for those under the age of 75 and yearly after this – a service that providers will typically charge £150 to £250 for. On the review date, a new maximum income is calculated based on the revised fund size and prevailing GAD rates – and set for the next period.
You may have already moved your clients over to flexi-access drawdown (FAD) but, if you still have clients in capped drawdown, it is worth revisiting. The key merit of staying in capped drawdown comes if a client’s circumstances have changed significantly and they want to put a good deal of new money into their pension, having started drawing on it.
In this scenario, in capped drawdown, you still have a full £40,000 annual allowance so you can pay that much each year into your income drawdown policy tax-free. In FAD, however, you are reduced to the much less generous £4,000 Money Purchase Annual Allowance (MPAA).
Annual allowance down
In the 2018/19 tax year, a UK taxpayer will enjoy tax relief on pension contributions of up to 100% of their earnings or a £40,000 annual allowance, whichever is lower. This number was £50,000 until 2014/15. Increasing numbers of individuals are now exceeding their annual allowance.
HMRC numbers from September 2018 show that, for the 2015/16 tax year, total annual allowance breaches cost UK taxpayers £179m. This jumped to £561m in 2016/17, in the year the tapered annual allowance for high earners came into effect.
While the government does not separate how much of the tax revenue came from high-earners on a tapered threshold from revenue generated by the standard annual allowance, it suggests the taper rules brought in from April 2016 may have had a significant impact on the tax take.
The tapered annual allowance for high-earners means they have less than £40,000 annual pensions contribution allowance (tapering down to a mere £10,000 with total earning levels). This calculation is so complicated Sir Steve Webb has actually advocated ending the taper.
Time to reconsider annuities?
Only about one in 10 defined contribution pension-holding retirees are currently buying annuities. Many advisers are still steering clients away from buying annuities post-pension freedom – often because they think annuity rates are so poor. It is, however, worth looking again.
Recent data from Moneyfacts shows the average annual annuity income rose by between 1.4% and 4.8% in the first half of 2018. So, it is up 14.6% since the Brexit vote back in June 2016 and now sits just 1.2% lower than when pension freedom came in the year before that.
Not only have core annuity rates begun to bounce back up – advisers do need to consider that it is increasingly likely there will be two pension-holders in many of their clients’ households. Depending on the wider circumstances, it may be better for one or even both partners to buy a single life annuity with no additional death benefits for the higher starting level of income. And if you do not link the annuity to inflation either, then the annuity being offered can start to look quite generous.
75th birthday pensions-tax hit
Finally, it is increasingly likely you will be looking after clients who are approaching their 75th birthday. 75 is not that old these days and some may only just have fully-retired by then. Pre-freedom, you used to have to buy your annuity before age 75.
Now, though, there is a different kind of cliff edge on that birthday in the sense that on death before age 75, any pension benefits can be paid as a lump sum or as a drawdown pension to any beneficiary tax-free, irrespective of whether they derived from uncrystallised or crystallised monies. But on death after age 75, any benefits will be taxable.
There is also a second test of the LTA at age 75, measuring the increase in fund size since crystallisation against any remaining unused allowance. It may be wise therefore to ensure your clients are not right on the LTA threshold as they approach age 75. Encourage clients to reduce the size of their overall pots in the run-up to that age. As a minimum, they should take all income from investment gains.
This may run contrary to some advisers’ thinking on keeping as much income invested for as long as possible but it makes sense in view of the fact more and more of us will be living to a ripe old age. If they do not need the income for current spending, it may be better to take it and give it away than paying a LTA tax charge at age 75. Giving away early can also help to reduce future IHT bills.
The reality is the three pensions tax allowance thresholds now controlling what benefits are subject to tax when in decumulation are all set low enough to catch more and more in-retirement baby-boomers each year. After all, upwards of 70,000 of them are reaching their 65th birthday every year in the UK for the next
15 years and nearly 19% of the total population of the UK is now over age 65.
There are, however, no signals from HM Treasury that this complex pensions tax web will be made easier anytime soon. So, an adviser with clients aged between 50 and 75 needs to build a plan that will dance around these allowances without incurring unwelcome tax charges.
Adrian Boulding is director of retirement strategy at Dunstan Thomas