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Phil Carroll: Using the new pension income rules in practice

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The Budget certainly put the cat amongst the pigeons with the unexpected and radical overhaul of the rules relating to pension de-cumulation. Other than the remote risk of every sensible person having a sudden financial breakdown and cashing in their pot to buy their dream Lamborghini, the changes appear to be great news for financial planners and their clients. Increasing the ISA limit to £15,000 and allowing a joint cash and equity ISA was just the icing on the cake.

Let’s consider this from a practical perspective. Amongst the benefits of the changes are the likelihood of a greater awareness of the different savings products and the greater flexibility of choice and access to funds than previously available.

How the changes might work in practice

The client is a 45-year-old male, higher-rate tax payer, with a pension pot today of £250,000. He is looking to either retire or take a career break at age 55 (when he has finished paying off his mortgage) and wants to know how he can ensure he is taking the most tax efficient income available to him from his investments.

Aside, from continuing to pay into Isas, his biggest area for consideration is increased pension contributions, as this will enable him to maximise the relief available.

As he can access a tax free lump sum of, generally 25 per cent at age 55, or a combination of tax free cash and ‘income’(which he can now take as and when he likes assuming the proposals made in the Budget come into force without amendment on 6 April 2015) he will give himself a solid starting point.

Increasing pension funding where relief is secured at 40 per cent, but tax on exit is at a rate of 0 per cent or 20 per cent will be very attractive to investors, especially due to the new flexibility introduced by the Budget.

Fast forward 10 years (for ease I have assumed the personal allowance stays the same), the client has amassed a pension pot of £520,000 and an Isa fund worth £70,000 and has no other debts.

If the full amount of available tax free cash (£130,000) is taken from his pension on his 55th birthday, he can move £30,000 in to an Isa by straddling the contributions over tax year end and move the remaining £100,000 into a collective.

To ensure your client’s investments are made as tax efficiently as possible, the Isa could be invested for income (to guarantee minimal tax leakage), the collective could be invested for growth (allowing use of the annual capital gains tax allowance), and the pension should be invested so that it delivers a return greater than the withdrawals over the medium to long term, meaning that an amount equal to the personal allowance can be taken without suffering tax.

The following strategy of withdrawing income (in theory) could then be adopted:

Income Amount Tax status

Income stream from ISA – say 5%

£5,000 pa

Tax free

Capital gain released each year from collective – say 7%

£7,000 pa

Tax exempt*

Pension drawdown – personal allowance value

£10,000 pa

Tax free

This would generate £22,000 of tax free income and gains annually.

Clearly, income and growth levels will vary, but having a combination of wrappers will enable the income requirements of the client to be as flexible as possible.

For example, if capital gains exceed expectation you could strip out more from the collective and leave the other investments alone to grow.

For instance, the FTSE 250 returned 28.8 per cent in 2013, assuming a client had invested £100,000 in a collective, which grew to £128,800; a withdrawal of £28,800 could be made without suffering capital gains tax.

This is because the part disposal rules mean only £6,440 of the withdrawal counts as capital gain with the remainder being a return of part of the original capital. This falls well within the CGT annual exempt amount of £11,000 based on today’s exemption. Unused capital could then be recycled back into the Isa fund or to make further pension contributions if allowed.

A further step that could be considered is combining all these wrappers on one platform, which can result in reduced charges, as well as simplified processes for switching, valuations and annual reviews.

One additional area to be aware of, which I have not accounted for in the above calculations, is the ongoing consultation over the potential inheritance tax levy where 100 per cent of available tax free cash is taken. However, this in itself presents another advice opportunity, as this will need to be considered along with wider assets and family circumstances.

According to the Office of National Statistics the average life expectancy of a 55 year old non-smoking male is at least 25 years. This year’s Budget has provided a number of opportunities for advisers to demonstrate value to clients through recycling and annual reviews. These opportunities have the potential to drive the need for further advice and revised strategies to work investments harder and avoid unnecessary tax leakage – not only over the short term but longer term too.  

*Within Annual Exempt Amount for capital gains (£11,000 for 2014/15)

Phil Carroll is financial planning expert at Skandia 

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