The problem. A client over 55 is looking to take a career break. As a higher-rate taxpayer, she normally has the income and the allowance to allow her to make a significant pension contribution but as she will not be earning a salary, what is the most efficient way to use the tax relief available to her?
Issues to look out for:
- The annual allowance for pension contributions
- As the client is over the age of 55, the ability to take a tax-free lump sum from a pension scheme
- Annual Isa allowance
- Without any earned income, the annual personal allowance for income tax becomes available
From a planning perspective, you can only use the rules you are presented with. A 50 per cent tax rate still exists, with the potential for 50 per cent pension tax relief. We all stress the need to make the most of reliefs but often it is a simple example that will make clients sit up and listen.
I have previously focused on the need to hold the right assets in the right wrappers and protect income and gains from unnecessary tax leakage. For people with high earnings looking to take a career break or restructure their investments, the following approach demonstrates how far we can stretch allowances and reliefs.
Protecting personal allowances and using capital gains tax to make up an income shortfall can save a significant amount of tax in a year of low earnings and can provide efficient return yields.
Let’s assume Ingrid had taken your advice and used allowances across 2011/12 and 2012/13. She is a high earner and has relevant earnings, so can make a pension contribution of £100,000 and benefit from 50 per cent relief on the contribution. She has moved income-producing assets into a tax-deferred wrapper and equity investments (low yield) into a collective scheme to enable future use of the CGT allowance. She had no other pension or Isa provisions to date.
Assuming Ingrid is over 55, wants to have a career break and planned the following strategy over the tax year end, then the £50,000 net investment would have created an excellent efficient income stream.
By using two input periods, one ending in the last tax year the other ending in this tax year, enables two years’ annual allowances to be used and will enable the pension commencement lump sum to be released and reinvested and create an income which is taxed way below the client’s expected rates.
So, the £100,000 contribution made would have cost Ingrid £50,000.
A lump sum of £25,000 would be released, resulting in the net cost of the pension being reduced to £25,000. An annuity could then be purchased, if required, to start in this tax year, which could generate an income of £4,500 a year if we assume an annuity rate of 6 per cent.
The released £25,000 is then reinvested in her Isa across two tax years (£10,680 in 2011/12 + £11,280 in 2012/13), creating an investment of £21,960, producing an income of £1,098 (assuming a 5 per cent yield).
The remaining £3,040 could be used for the rainy day fund or to pay for round-the-world tickets.
The annuity income could well fall within Ingrid’s personal allowance for that year due to other assets being held efficiently. The combined income is the equivalent of £11,196 for a 50 per cent taxpayer, £9,330 for 40 per cent and £6,997 for a 20 per cent tax payer. The net cost to Ingrid is £25,000 but the benefit is significantly greater. We have created an individual paying virtually no tax, £21,960 into their Isa and an annuity income of £4,500 for life (or a pension pot £75,000). Reality might mean this cannot be achieved in such a perfect way but the principles of holistic planning can demonstrate real value for clients.
Phil Carroll is head of financial planning at Skandia