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TAX TIP: Immediate vesting pensions are growing in popularity with retired investors looking to generate income
August 4, 2009

With the Bank of England's base rate remaining at 0.5 per cent and average one-year fixed savings rates paying just 3.04 per cent, investors are still scrambling for ways to generate income. One little known route that is increasing in popularity is to buy a pension and immediately convert it into an annuity. Known as an 'immediate vesting pension', this can generate an income of between 5.44 per cent and 11.44 per cent, depending on your age and gender.

Here's how it works: most investors aged between 50 and 75 are able to pay £3,600 into a pension each year. However, it's no longer necessary to be a taxpayer in order to receive tax relief on pension contributions, so you actually only need to pay in £2,880, and the government will add another £720, making a total of £3,600.

Investors then receive £900 back as a tax-free lump sum, reducing the effective cost down to just £1,980 (£2,880 minus £900).

Investors can receive their whole first year's income immediately, the amount of which is dependent on the investor's age. The older the investor is, the bigger the overall return as annuity rates increase with age.

The attractions are greater for higher-rate taxpayers because they get more tax relief from the government, contributing just £2,160 of the £3,600 themselves. Note, though, that you will have to claim the extra relief back via self-assessment.

Nigel Callaghan, pensions analyst with Hargreaves Lansdown says: "Investing £3,600 into an instant income pension will produce a far higher return than most savings accounts, giving beleaguered savers' income a much needed boost."

However, there are several possible downsides:

First, investors immediately forgo the capital that is invested. The income will stop upon their death. If that is before their average life expectancy, they may not have received their original investment back. The younger you are, the smaller the annual income paid out by your annuity and the longer you have to live to receive your original investment back.

Second, investors with small pension funds can opt to take their entire funds as a cash sum rather than having to purchase an income. The current overall limit is £16,500. If a payment into this arrangement means their total funds were more than £16,500, they would lose this lump sum options.

Third, the Revenue is concerned about investors recycling their pension tax-free lump sum (usually 25 per cent of the entire fund) to make further 'significant' contributions into pensions. However, Hargreaves Lansdown believes payments of under £3,600 are unlikely to breach these rules.

Also note that your annuity income is subject to income tax.

Instant Income Pension: What’s the Rate of Return?

MaleFemale
Age now(£) Annual (£) Total income over average lifetime* % return from net investment (£)Annual income(£) Total income over average lifetime*% return from net investment
60132.752,9207.20%121.173,0296.50%
65150.432,7078.20%136.562,7317.40%
70175.332,4549.70%158.132,5308.70%
74203.392,23811.45%181.412,35810.10%

*These projections are based on current Government Actuarial life expectancy assumptions

Source: Hargreaves Lansdown

• See annuity rates table at www.ft.com/annuitytable for more on annuities.