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Recycling an income

With the launch of the Government&#39s website for silver surfers last week,

we can expect those of retirement age to become increasingly well informed

about their financial affairs. But tax planning concepts will probably need

a little help from financial advisers for some time to come.

Take the tax regime introduced with stakeholder in April. Who would have

believed it would bring a radical new dimension to retirement planning? The

simple fact that someone who has retired can carry on contributing £3,600

every year until age 75 changes the way many higher-net-worth clients, in

particular, may plan their post-retirement finances.

One example of the new possibilities for tax planning is income-drawdown

recycling. Let&#39s take a client who retires at 60 and whose earnings were

£80,000 in any one of the five years preceding retirement. The new tax

rules say, if earnings prior to retirement could have justified

contributions over £3,600, higher contributions can be continued for a

further five tax years after earnings have ceased.

Furthermore, the higher contribution can be based on the highest earnings

in the cessation year (his last year with net relevant earnings) or any of

the five preceding tax years. These earnings are applied to calculate

maximum contributions in the break year (the first year of nil earnings)

and the subsequent four years.

Our client will have attained age 61 at the start of the break year so

he can contribute a sum of £32,000 a year for that year and the next four

years before contributions reduce to £3,600 until age 75.

As a wealthy individual, he does not currently need to look to his

personal pension for income purposes but the prospect of unlocking his

tax-free cash to repay a mortgage or purchase a retirement property or

other investment could have considerable appeal. So he takes the pension

fund of £711,110 which he has built up and effects a drawdown policy.

After taking his tax-free cash of £177,777, he is left with a residual

fund of £533,333. Taking a gilt yield of 4.75 per cent as an example, this

would deliver a maximum withdrawal of £41,600 gross based on income at 100

per cent of the limit set down by the Government Actuary&#39s Department.

If the client does not actually require that level of income, the

flexibility of income drawdown would normally be used to take the minimum

35 per cent ofthe GAD limit, namely, £14,560 gross.

But now a new possibility opens up. Taking the maximum withdrawal of

£41,600, assuming he is liable for tax at 40 per cent on all this, the net

amount received would be £24,960. This is now reinvested as a personal

pension contribution and grossed up by the provider with basic-rate tax

relief of 22 per cent to become £32,000.

Having established basis year earnings of £80,000 prior to retirement, he

is able to make this contribution to a personal pension and can also claim

higher-rate tax relief of £5,760 through his tax return. He will, in

effect, have received income of £9,600 – the gross withdrawal less the

gross contribution – and paid tax of £3,840 on it.

Two key advantages emerge from this approach. First, the £32,000

contribution reduces the drawdown fund on which 35 per cent tax will be

payable on his death and builds up

a new phased retirement plan payable free of tax on his death. Second, the

new plan delivers 25 per cent of the fund as further tax-free cash when he

chooses to take benefits under it.

This example may be a little extreme and deal with very high levels of

contribution but it demonstrates a concept which can be used flexibly to

meet any particular client&#39s needs. Of course, everyone can use the idea

for a gross contribution of up to £3,600 to age 75 if they do not need the

maximum income they could take from their drawdown contract.

It is worth remembering that this facility is available to existing

income-drawdown clients, at least at the £3,600 gross contribution level.

Clients whose first year with no earnings is 2001/02 (essentially those who

retired in the fiscal year 2000/01 or later) may also be able to use the

cessation rules to contribute more than £3,600 based on their highest

earnings in any fiscal year starting 1995/56. Earnings while a member of an

occupational scheme do not, of course, count but all other earnings do.

There is a general warning which needs to be applied when using the

five-year cessation rule. Any further earnings will immediately take the

client back to using the five-year presumption rule which applies when

people are building funds during employment. Contributions over £3,600 can

still be made based on earnings in a basis year but only for that year and

the five subsequent tax years. So the period may be less than can be

sustained using the cessation rule.

In other words, even small earnings in retirement may remove access to an

old basis year resulting in the planned drawdown recycling no longer

working at the planned contribution level.

Wealth management and tax planning opportunities in the grey market – or

for silver surfers – represent a hugely significant opportunity for

financial advisers, with income drawdown recycling just one new feature.

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