Pension contributions – Are they still worth it?

Although there has been a tremendous amount of bad press with regard to pension schemes in recent months we remain convinced that contributing to a registered pension scheme still makes sound financial sense, particularly if you can leverage your pension assets to build a really substantial pension…..

The shock attack on tax relief for pension contributions in recent years and the recent bad press about pension charges has made many people question whether such pensions are still a worthwhile investment. This view is compounded by the poor returns from investment funds of late.

Recent attacks on aggressive tax avoidance

There have been wide spread reporting in the press with regard to the “morally repugnant” routes of tax avoidance, pensions however are a legitimate and authorised means of reducing your tax bill and the contributions are deducted from your highest rates of tax.

Furthermore the generous carry forward allowances allow for creative tax planning both for individuals and employees.

The three year carry forward rule

If you save more than £50,000 in your pension you still might not have any annual allowance charge to pay. You can carry forward any annual allowance that you have not used from the previous three tax years to the current tax year. The amount of the unused annual allowance can then be added to this year’s annual allowance. This gives you a higher amount of available annual allowance.

You must have been a member of a registered pension scheme to have an unused annual allowance to carry forward from an earlier year.

If your pension saving for the tax year is less than your available annual allowance there will be no annual allowance tax charge.

If your pension saving is more than your available annual allowance you will have to pay the annual allowance charge – but only on the amount over your available annual allowance. You will not need to contact HM Revenue & Customs (HMRC) to tell us that you have unused annual allowance that you want to use to set off against an annual allowance charge for a later year. This doesn’t need to be included on your Self Assessment tax return.

There is a strict order in which you use up your annual allowance. You use the annual allowance in the current tax year first. You then use your unused annual allowance from earlier years, using the earliest tax year first.

If you have been a member of a registered pension scheme but, in one particular year, have not made pension savings for that year then you can carry forward an annual allowance of £50,000 from that year. If however, you have not been saving in a registered pension scheme then you will not have unused annual allowance to carry forward from that year.

However with all of the examples provided, as in reality, you can only obtain tax savings against your actual earnings in any one financial year. So it would be pointless to roll forward your allowances for any amounts above your earnings limit.

Example

Brian has total pension savings of £65,000 for the 2012-13 tax year.

In the previous three tax years his pension savings were:
2011-12 – £35,000
2010-11 – £30,000
2009-10 – £25,000

If the annual allowance for each of those years was £50,000 Brian has unused annual allowance of £25,000, £20,000 and £15,000 from those three tax years:
2011-12 – £15,000
2010-11 – £20,000
2009-10 – £25,000
2010-11 – £60,000

This means Brian has £60,000 unused annual allowance to carry forward.

Together with the £50,000 annual allowance for the 2011-12 tax year. Brian’s can have pension saving of £110,000 without the annual allowance charge being due.

Brian’s pension saving for the 2011-12 tax year is less than his available annual allowance. He will not have to pay the annual allowance charge.

 Work ’til you drop

Any financial planner worth his salt will consider the client’s entire lifestyle before advising on any long-term investment decision, not just the client’s immediate cash position and expected date of retirement. The client will be asked to provide details of all his assets, income and liabilities, together with a view of his personal and business objectives. For example: the client may see himself working in his own business ‘until he drops’. All this data can be fed into a sophisticated model that can forecast the client’s financial needs well into the future, up to age 100 if necessary. This financial modelling will also highlight where cash shortfalls are likely to occur.

The financial planner will suggest a number of ‘what-if’ scenarios to meet these shortfalls, some of which may involve pension contributions. The total solution will include a review of the client’s current savings vehicles to reduce any unnecessary charges, and increase performance if possible.

For example, there is normally a good case for ensuring that ISA contributions are paid up to the annual allowance. Remember that the ISA contribution limits have increased to £11,280 from 6 April 2012.

If there is a shortfall

The individual may not be able to afford the increased level of monthly pension contributions that are needed to meet the predicted cash shortfall. If the individual has a number of years before retirement it may be possible to increase the value of the overall pension by intervening at an early stage. As a first step it is often helpful to streamline any existing pension arrangements, perhaps by amalgamating funds with a single provider.

Where the individual is a business owner, a flexible self-invested pension scheme can be established under the SIPP or SASS rules. Funds from a variety of existing pension schemes may be able to be transferred in to the SIPP or SASS, which may provide for savings on overall charges and hopefully the total consolidated funds will be managed far more efficiently.

Loans to employer

There is the possibility of a pension fund such as a SASS arrangement to make a loan to the employer – up to 50% of the value of the fund to the sponsoring employer company, if all of the following conditions apply:

  • the loan is fully secured on an acceptable unencumbered asset;
  • the period of the loan does not exceed five years;
  • interest and capital is repaid evenly at one-year or shorter intervals; and
  • the interest rate must be commercial (as a guide the interest rates should at least be 1% above the average base lending rates of the main high-street banks).

The scheme trustees cannot lend directly to the scheme members or to any entity connected with the member that is not the sponsoring employer.

Funding a property purchase

A SIPP or SASS pension fund can purchase a commercial property to be used by the business, or as a pure investment. The trustees can borrow 50% of the fund’s value to purchase a property, and they can combine with up to four other co-owners to purchase a larger property. Such a property could be sub-let to provide an additional income stream for the pension fund.

If you are familiar with my planning then you will be aware of how beneficial such an arrangement can be if carried out in conjunction with astute planning, it combines two strategies I favour for wealth creation, namely leverage and OPM (other people’s money). So having established a base pension one can create a larger fund and then other people ( the tenants of the property will make payments that reduce the debt created by the loan over time – leaving you with a much bigger pension fund).

When is retirement?

These days many people continue to work to some extent during their retirement, perhaps on a voluntary basis to keep physically and mentally active. This merger of work-life and retirement is reflected in the pension rules, as individuals are permitted to start to withdraw monies from their pension from age 55*, or a later age specified in the pension scheme rules, whether they have ceased working or not.

What does drawing pension benefits mean?

When an individual starts to access his pension benefits he can opt to receive a cash-free lump sum of up to 25% of his pension fund assets, but can defer the payment of a regular pension until he needs that income. This tax-free pension commencement lump sum can place a significant sum in the member’s hands immediately reaching age 55. However he may decide to delay taking pension drawdown regular payments until he has effectively retired from work as otherwise he will be taxed both on his earnings and pension receipts.

Common pension mistakes

No investment should be made without considering the charges to be levied, the growth prospects and, crucially, the affordability. Pension contributions are no different, but these aspects are often overlooked. When setting up a regular pension contribution, beware of the following:

  • The pension provider may deduct high initial commissions.
  • We do not advise business owners to make monthly contributions. It is far better for a business owner to time his payments just prior to his financial or trading year-end and may be easier for the business to manage.
  • Review the range and growth performance of the funds the pension provider offers.

Conclusion

In spite of some bad press recently, pension contributions are still a very tax-efficient way of providing a future income stream. The investments within the fund are not taxed and tax relief is received on contributions, at varying rates depending on who makes the contributions.

However for business owners particularly pensions can be a boon as they can be designed to be a dynamic planning tool both for the business and for wealth creation.

So yes, pension contributions are still worth it — as long as you take the right advice.

This article provides a general review and its purpose is to inform, not to recommend any specific investment or course of action, you should always seek professional advice.

The value of investments and pensions is not guaranteed and on maturity or encashment, you may not get back the full amount of money invested.

EXAMPLE

Bruce is aged 65 and a director of Strictly Ltd, which makes a pension contribution of £100,000 on 1 March 2010 into its occupational scheme on Bruce’s behalf.

Strictly Ltd pays corporation tax at a marginal rate of 26%, so the net cost of the pension contribution after corporation tax relief is £74,000 (£100,000 — 26% x £100,000). Bruce is old enough to start drawing his pension immediately, so withdraws a tax-free lump sum of £25,000.

Bruce can also start to take a regular pension of £4,800 a year. Since he is still working and paying tax at 40%, his net pension income is £2,880 (60% x £4,800). However wisely Bruce decides to delay taking regular pension withdrawals until he formally retires from the company as the tax deductions from regular pension payments may then be lower.

Ray Best can help you protect your financial future. To find out more, simply click here!

About Ray L Best

Ray Best has had over 30 years experience of advising on complex financial matters. A published author of a number of books including “Partnership and Shareholder Protection”, Inheritance Tax Simplified”. We provide an initial meeting at no cost and only engage with clients when we can add significant value.

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