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Executive stress

Standard Life marketing technical manager John Lawson shows how taking out an executive pension plan before A-Day can bring big knock-on benefits.

What you are about to read is a technical article but before you skip straight to the next page, for anyone who might need insurance against the lifetime allowance charge, it is worth getting your head around an executive pension plan.

To illustrate the argument, let us start by assuming that we have identical twin brothers, Jack and James. They are in their late 20s, they have gone into business together and both earn 60,000 a year. They started the business five years ago and neither has yet started a pension.

Jack first has heard all about A-Day but cannot see the point of starting a pension now. After all, he can pay in 100 per cent of earnings and the business can pay into a pension for him without limit after A-Day dawns. So why bother trying to get his head around all this complex stuff now?

Fast-forward 20 years and Jack is now approaching 55, which is the earliest age at which he is allowed to draw his pension. Jack started his pension saving just after A-Day. The business did so well that the brothers decided to shelter as much of their profit as they could within their pension.

With the help of his adviser and using lifetime allowance projection software, Jack had always tried to keep his fund within the lifetime allowance but the fund and the lifetime allowance did not behave as expected. The Treasury handed out too much tax relief and the lifetime allowance has been frozen for the last five years. Jack’s fund also performed better than expected thanks to some excellent recommendations from his adviser. As a result, Jack’s fund is 3.5m and the lifetime allowance is now 2.5m.

If Jack vests – sorry, crystallises – his pension fund, he will get tax-free cash of 625,000 (a quarter of the standard lifetime allowance of 2.5m). The 1m in excess of the lifetime allowance will be taxed at 55 per cent if Jack takes it as a lump sum. So Jack’s total lump sum is 625,000 + (1m x 45 per cent) = 1,075,000.

The remainder of his fund (1.875m) must be used to buy a pension.

Assuming that Jack pays 40 per cent tax, over his whole retirement, on the amount used to buy the pension (40 per cent of 1.875m) and 55 per cent tax on the 1m over the lifetime allowance, the total tax Jack will pay is 1.3m.

Jack’s twin James took a different route. He met a smart financial adviser just before A-Day who told him to fund an executive pension plan before April 6 2006. James paid in a contribution of 20,000 and his tax-free cash at A-Day was 11,250 (five years x 3/80ths x 60,000). As a proportion of his pension fund, his tax-free cash was 56.25 per cent.

James did not realise it at the time but the fact that he was entitled to more than 25 per cent tax-free cash in a pre-A-Day pension was important. When James reached 55, like Jack, his pension fund was also 3.5m.

If James crystallises his pension fund, his tax-free cash is calculated as two separate amounts. The amount accrued before A-Day is simply increased in line with the lifetime allowance. So we have 11,250 x (2.5/1.5) = 18,750.

His post-A-Day tax-free cash is calculated according to the formula in figure 1 (below).

Like Jack, assuming James pays 55 per cent on the 1 million of his fund above the lifetime allowance and 40 per cent, over his whole retirement, on the part of his fund that he must use to buy a pension, his total tax is worked out as follows: (1,752,084 x 40 per cent) + (1m x 55 per cent) = 1,250,833.

James has received a total lump sum of 747,916 + (1m x 45 per cent) = 1,197,916.

James’s strategy has paid handsome dividends in two respects: he will pay nearly 50,000 less tax than Jack over the course of his retirement; and as he receives a greater proportion of his retirement benefits as cash (120,000 more than Jack), he has much more freedom over how he spends his retirement savings.

As noted above, this is due to the fact that different tax-free cash calculations apply if the individual has an entitlement to more than 25 per cent. The rules are contained in paragraphs 31 to 34 of Schedule 36 of the Finance Act 2004. These override the normal tax-free cash rules contained in paragraphs 1 to 3 of Schedule 29 of the same act.

So, there you have it. Anyone who can should take out an executive pension plan (or join any money-purchase occupational pension scheme) and build up tax-free cash greater than 25 per cent of the fund before A-Day. By doing so, they can reduce the amount of tax that they would pay if they should breach the lifetime allowance at their eventual retirement.

Figure one

James’ post-A-Day tax-free cash calculation

Fund at retirement LESS lifetime allowance charge LESS fund at A-Day MULTIPLIED BY the increase in lifetime allowance DIVIDED BY 4

So, for this second part, we have:(3.5m – 550,000 – (20,000 x 2.5/1.5))/4 = 729,167Total tax-free cash is, therefore: 18,750 + 866,667 = 747,916

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