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Look beyond pensions for tax efficiency

Our reader should look to build up assets in tax-efficient wrappers other than pensions
August 31, 2017, Jason Hollands and Rob Morgan

Graham is 43 and married with two children aged six and eight. He hopes to retire at 57 or, if his financial situation allows, 55. He has been saving into a self-invested personal pension (Sipp) for 10 years and an individual savings account (Isa) for five years, and has a private pension with Standard Life that he contributed to when he was in his 20s.

Reader Portfolio
Graham 43
Description

Sipp, Isa, workplace pension and residential property

Objectives

Retire early

Portfolio type
Investing for goals

Graham and his wife own their home, which is valued at about £1.6m. They have a tracker mortgage of £415,000 on it and at the moment only pay interest of 0.74 per cent. Graham’s late father also left him a property and a will trust with a value of £130,000, one-third of which will pass to him after the death of his father's second wife.

"My investment aims are capital growth until I retire at age 57, and after that income of 4 per cent a year," says Graham. "My Isa and Sipp will be my main sources of income.

"I salary sacrifice everything I earn that falls into the 40 per cent tax bracket – currently £35,000 a year – and my employer passes on its National Insurance saving to me. This provides me with a 15.8 per cent tax break – 13.8 per cent employer National Insurance saving plus 2 per cent personal National Insurance saving.

"Assuming equity returns of 3 per cent a year, if I continue my contributions at their current rate, with the effects of compounding, my Sipp will hit the £1m lifetime allowance by 2021 when I will be 48 – nine years before my planned retirement. If I continue to contribute to my Sipp with these same assumptions it will get to a value of £1.3m by the time I am 57.

>"I would say that my investment risk appetite is moderate to high – I could tolerate a loss of up to 15 per cent a year"

"Any pensions savings over the £1m lifetime limit attract a tax charge of 25 per cent in addition to income tax at your nominal rate, if it is withdrawn as income. So I plan to only withdraw income from my Sipp, up to a limit that won't incur the higher rate of income tax – income taken up to £1m would in effect be taxed at 20 per cent. And the pensions lifetime allowance is to be index-linked from 2018 so the £1m limit will slowly increase. I don't plan to withdraw the 25 per cent tax-free lump sum.

"My Sipp will continue to pay a pension to my wife or myself when one of us dies. Any residual fund can be used by our children for their pension without any inheritance tax (IHT) liability when the second person dies.

"I would say that my investment risk appetite is moderate to high – I could tolerate a loss of up to 15 per cent a year. I am generally a buy-and-hold investor, so only make four or five trades a year. But I do keep a close eye on the performance of individual funds within my portfolio, and sell them if they consistently underperform.

"I increasingly buy low-cost trackers rather than active funds, and recent purchases include Land Securities (LAND), Vanguard US Equity Index (GB00B5B74S01) and Fidelity European (GB00BFRT3504).

"I am thinking of investing in Close FTSE Techmark (GB00B87JKQ15) and iShares S&P 500 UCITS ETF (IUSA)."

 

Graham's portfolio

Holding

Value (£)% of portfolio
Alliance Trust (ATST)11,618.281.68
BlackRock Frontiers Investment Trust (BRFI)5,9900.87
Invesco Perpetual European High Income (GB00B8N45766)6,973.811.01
Stewart Investors Asia Pacific Leaders (GB00B57S0V20)17,010.162.46
Stewart Investors Global Emerging Markets Leaders (GB0033874545)35,179.405.09
Fidelity Special Situations (GB00B88V3X40)36,510.435.28
Fidelity European (GB00BFRT3504)24,2853.51
Henderson Global Technology (GB0007716078)13,239.731.91
Land Securities (LAND)9,538.661.38
Legal & General UK Index Trust (GB00B0CNGN12)71,715.6710.37
HSBC FTSE 250 Index (GB00B80QFZ35)9,628.881.39
HSBC European Index (GB00B80QGD89)22,643.363.27
HSBC Pacific Index (GB00B80QGT40)16,598.572.4
iShares Emerging Markets Equity Index (GB00B84DY642)23,850.303.45
Old Mutual UK Smaller Companies (GB00B1XG9599)31,353.254.53
Artemis Income (GB00B2PLJH12)22,219.103.21
Jupiter India (GB00B4TZHH95)13,485.761.95
Schroder UK Alpha Plus (GB00B5L33N61)17,458.212.52
Schroder Tokyo (GB00B4SZR818)25,008.013.62
Scottish Mortgage Investment Trust (SMT)43,876.656.34
Vanguard FTSE U.K. All Share Index (GB00B3X7QG63)44,349.376.41
Vanguard U.S. Equity Index (GB00B5B74S01)73,352.7410.61
Standard Life Pension Millennium With Profits Fund2,377.810.34
Standard Life Pension With Profits Fund837.620.12
Standard Life European Equity Pension Fund15,053.022.18
Standard Life UK Equity Pension Fund 41,542.406.01
Final bonus1,641.500.24
Stewart Investors Indian Subcontinent (GB00B1FXTG93)9,887.111.43
Liontrust European Income (GB00BD2WZ436)4,606.170.67
Invesco Perpetual High Income (GB00B8N46L71)5,421.690.78
Invesco Perpetual Income (GB00B8N46V79)5,308.440.77
Jupiter Financial Opportunities (GB0004790191)3,913.160.57
Standard Life Aberdeen (SLA)5,103.820.74
Cash19,975.702.89
Total691,553.78 

NONE OF THE COMMENTARY BELOW SHOULD BE REGARDED AS ADVICE. IT IS GENERAL INFORMATION BASED ON A SNAPSHOT OF THIS READER'S CIRCUMSTANCES.

 

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

You're doing a lot right here. You've got a heavy weighting in tracker funds. You've based your strategy on very realistic expectations and are on course to meet your objectives – an assumption of 3 per cent annual equity returns might even be a bit pessimistic. And you are looking to take your income in a tax-efficient way.

However, a danger with trying to reduce tax liabilities is that the tail can wag the dog. Investment and consumption decisions can get distorted, because tax minimisation becomes an end in itself rather than what it should be – a means of enjoying a better standard of living.

You've avoided some of the riskier ways that people try to minimise tax, such as investing in overpriced Alternative Investment Market (Aim) stocks and questionable film finance schemes. But your use of salary sacrifice has created a problem. About 90 per cent of your investment portfolio assets are held in pensions, whereas my pensions are only around 60 per cent of my overall assets.

So not only do you face the possibility of bumping up against the pensions lifetime allowance, there's also regulatory risk – the danger that the £1m allowance will be reduced. 

And as you can't take money from your Sipp until you're 55, if you lose your job what will you live on? But if you can live comfortably today on an income below the 40 per cent tax threshold, you should be able to retire comfortably with your current plan. 

You could put less into your pension and more into your Isa. This would reduce the risk of your pension hitting the lifetime allowance limit, and might allow you to retire before age 55 if we get decent equity returns – you could simply run down the Isa.

This comes at a price, though: to raise the money to contribute to the Isa, you'll have to give up some salary sacrifice and incur higher taxes today. 

You don't have to address this immediately. Given that you're some way below the pensions lifetime allowance you could continue with your strategy for now, and shift to making smaller pension contributions and higher Isa contributions at a later date.

I am puzzled by your reluctance to take the 25 per cent tax-free lump sum from your pension. This is one of the main attractions of a pension – that lump sum alone could give you years of tax-free income.

Taking the lump sum reduces the amount you can leave to your children. But it would also leave your other assets untouched, meaning the returns from them should compound nicely. For someone keen to minimise tax, that lump sum should be very tempting.

 

Jason Hollands, managing director at Tilney Group, says: 

You are in a strong financial position for someone in his early forties, with a £1.6m property, a low loan-to-value ratio on the remaining mortgage and a decent sized investment portfolio.

You have a relatively ambitious goal of retiring in your mid to late fifties but which is achievable given the way you are funding your Sipp through salary sacrifice. There is a no certainty that the current level of tax reliefs for pensions will remain in place or that salary sacrifice will remain an option, but for now you can only make plans based on what is known and maximise the value of these reliefs.

Many older pension plans are not able to accommodate the flexible options introduced under recent pension reforms. So find out as to whether it would be a good idea to consolidate the Standard Life pension into your Sipp by checking out whether there are any significant exit penalties or loss of benefits if you do this.

 

Rob Morgan, pensions and investments analyst at Charles Stanley, says:

Pension contributions, as they stand, are efficient – even if they incur the pension lifetime allowance charge. But pensions and tax rules can change, so you may wish to consider some other options for how you invest in the future.

New venture capital trust (VCT) subscriptions, for example, offer 30 per cent income-tax relief, provided the shares are held for at least five years, and all growth and income is tax-free. But VCTs tend to be high risk, even though some are relatively conservatively managed, so they should be used in moderation. They could form part of a tax-efficient income-producing portfolio in retirement – one can expect a fairly consistent yield of 3 per cent to 5 per cent from them. There is no limit on the number of VCT shares you can accumulate, although you can't invest more than £200,000 in them per tax year.

Another option is to invest in your wife's name: even if she has no earnings she can contribute £3,600 gross – a payment of £2,880 net – per year into a pension. If she is a non-taxpayer when taking benefits this could be highly effective, albeit with a modest amount. Also, if she is under 40, she could invest up to £4,000 a year into a Lifetime Isa to which a 25 per cent government bonus is added – essentially equivalent to basic-rate tax relief. She could take the money out of a Lifetime Isa penalty-free from age 60.

Using a variety of these alternative tax-efficient pots for some of your investments in future might open up some tax planning opportunities – and it would also mean being less reliant on pension rules remaining as they are.

Isas and VCTs are less attractive from an IHT perspective relative to pensions, but if that's an issue you could draw them down first, leaving the pensions intact for longer.