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Keep it in the family

Simplification is set to change the world of pensions forever.

Due to take effect from April 2006, the sweeping reforms outlined in the Inland Revenue Green Paper which are due to be enshrined in the Finance Act 2004, will usher in a whole new way of investing in pensions.

Gone will be the pettifogging rules and regulations applying to eight different tax regimes, with just one annual limit of £215,000 and a lifetime limit of £1.5m to watch out for.

The facility to buy residential property for the first time within a pension fund with gearing of 50 per cent of the value of the pension fund (at the time the loan is made) has caused much comment, not least because of fears that individuals will over-invest in property to the detriment of their overall fund.

You can already invest in commercial property within a Sipp, borrowing up to 75 per cent of property valuation. But from April 2006, investment in residential property, including holiday homes and buy-to-lets, will be possible via Sipps for the first time.

Properties such as buy to let and holiday lets, which currently involve payment of income tax on rental income and capital gains tax on sale, could benefit substantially from being placed inside a Sipp. But remember that any personal use of such properties would constitute a benefit in kind with tax payable on the benefit at your marginal rate.

So personal use for one month a year of a holiday home which is normally let out the rest of the year at £2,000 a month would generate a tax charge of £800 for a higher-rate taxpayer.

You could also buy (and furnish with antiques) properties for your children and place these within your pension fund, although remember that you may eventually need to sell such properties when you need to take your pension, so the beneficiaries would need to be made fully aware of this.

We are disappointed that borrowing from 2006 will be limited to 50 per cent of pension fund value at the time a loan is made rather than the current 75 per cent of property valuation. This means if your fund is worth £500,000, you would be able to borrow up to £250,000 under the new rules to buy a property valued at £400,000, whereas under the current rules you could borrow up to £300,000.

But there is nothing to stop you borrowing against equity in your own property or other assets to fund pension contributions up to your net relevant earnings, subject to the annual cap of £215,000 in the tax year 2006-07.

For instance, say, your salary in the tax year 2006-07 is £100,000, you could borrow up to 100 per cent of this sum by withdrawing equity from your own property (or borrowing against other assets) and put this money towards investing in a residential property and get 40 per cent tax relief on your contribution, or £40,000 (assuming you are a higher-rate taxpayer).

If you wanted to transfer properties you already own into your pension fund after April 2006, you would have to sell and repurchase them, incurring CGT and stamp duty.

But once in the fund, such properties would be free of CGT and income tax on any rental income, but all property-related bills such as insurance, repair and maintenance, service charges and council tax bills would have to paid out of the pension fund rather than from your own pocket.

You could even buy your own property and place it in your pension fund, providing you were willing to pay tax on the benefit in kind. If the monthly rental value of the property is £1,500 a month (£18,000 a year), as a higher-rate taxpayer you would have to pay £7,200 a year income tax on the benefit in kind.

The Green Paper appears to suggest that if you set up a “Family Sipp” (for, say, two parents and two children), the value of the house on death could pass from the father to the spouse and two children.

For example, you own a £300,000 property which you sell to your family Sipp, in which your wife and two children are members with their own individual funds. At retirement, you take income draw down to pay yourself a pension and at age 75 you continue doing drawdown via Alternatively Secured Income (ASI).

Section 3.7 of the Green Paper states that the benefits within a scheme may be reallocated to pay pension benefits to other scheme members on the death of one of the members. So when you die, instead of the fund passing back to the insurance company, the house could be sold and the value split between your wife and two children.

This may all seem like good news but pension experts warn against committing too much of a pension fund to one asset. The housing market is overheated and the Bank of England has warned of the dangers of a property bubble.

Also, if you are overweight in property by the time you reach age 75 you may have to sell in order to purchase an annuity with 75 per cent of the fund unless you can afford to do drawdown or ASI.

Investors would be far better off taking advantage of the very wide range of investments allowed within Sipps to build up a well diversified investment portfolio, without overallocating to any particular asset class.

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