TT194: Avoiding the new pension’s trap
Are you walking blindly into the new pension’s trap? As of April 5th this year the rules in relation to the size of an allowable pension fund will change. There have already been numerous changes in recent years, as governments try to reduce the costs of, what they see as, a generous benefit. Pension schemes do provide tax advantages for investment, and of course, a tax-free lump sum of up to 25% of the fund value at benefit crystallisation. So pension schemes do provide an excellent vehicle for retirement saving especially for those in the higher tax brackets. For shareholding directors they can provide a very efficient business management tool that allows tax efficient profit extraction and future business use of the funds before retirement.
The problem is that where accumulated funds exceed the lifetime limit when crystallisation takes place, a tax charge of 55% can take a significant bite out of the excess funds. Currently, the lifetime limit stands at £1.5 million. I am sure many of you are thinking, ‘well that should be enough for anyone’. However, at current annuity and pension drawdown rates, you may find that this only provides an income of £60,000 per annum. However in April of this year the lifetime limit will be reduced to £1.25 million. If your pension fund is likely to exceed this new lower level before you draw benefits you may want to take suitable action. Before you get to thinking that even if you are likely to hit this level, inflation should take care of it, think again! History would not be on your side here. The current limit of £1.5 million was introduced in April 2006 (pension simplification) and was set to rise by inflation with a target of £1.8 million by 2011.Since then however the limit has been reduced back to £1.5 million (April 2012) and is now due to fall again in April 2014. It appears highly unlikely that the government will reverse this direction. The best we can hope for is that the new limit is maintained.
This means that individuals who are currently well below the threshold need to sit up and take notice! Looking at various scenarios below you can see the potential issues.
John is 48 and planning to take benefits at age 60. His current fund value is £765,000 and therefore he feels comfortable that he is well below the new limit. John however currently contributes £20,000 per year into his scheme, and being an entrepreneur, has a relatively aggressive investment approach. Let us assume that he expects a 9% return per year on his pension portfolio. At age 60, John will have a fund valued of £2,554,502 and a potential tax charge of £717,476!
Jill is a little more conservative in her pension investment approach. Whilst still entrepreneurial, Jill feels that she has taken her greatest risk in going into business for herself. The profits that she sets aside for her future need to be preserved. She is now approaching 55 and feels that she could not build her retirement pot all over again. At the current time, her pension fund is worth £650,000 and her more conservative portfolio is expected to produce a return of 6% per year. Jill still enjoys running her business however and feels that she will not draw on her pension funds before age 70. Jill has reduced her contributions in recent years as her business environment has been tough. Currently Jill contributes £10,000 per year. The bad news for Jill is that even on her current contribution level she will exceed the £1.25 million threshold by £540,552 and suffer a tax charge of £297,303. Even if Jill stops her current contributions she will have a pension fund of £1,557,762 at her planned crystallisation date. Jill needs to rethink both her pension and profit extraction strategy.
As you can see even those who currently have a fund value well below the lifetime limit still need to think about this over the long term, depending on their current contribution levels and anticipated growth rates on their fund.
There are ways to protect the benefits already accumulated from the tax charge, however time is short as action will be required before April 5th this year. If you are concerned that you could be falling into the pension trap call us to discuss how to protect yourself.Talk to Barnes Roffe today