Pre-retirement

It’s a long one! So please bear with me.  

When you are looking to build your retirement assets you need to have a clear goal, as without it, you cannot plan how to achieve it. The goal will need to be financial and I have already covered how to calculate it in the previous chapter. There is now wrong answer – and as I highlight a lot in this book, there is no magic ‘one size fits all’ number. It’s unique and personal depending on your goals.

So hopefully you have now calculated your required capital sum. Now we need to work out how to get there, and obviously the longer time we have to achieve this, the less it will cost either in risk taken or money paid in.

Ok. So most commonly we use pension wrappers as the main tool to fund retirement. Pensions, since George Osborne announced pension freedoms in 2014 which later implemented in 2015, are confusing. They are full of pit falls - but absolutely amazing for doing what we need them to.

The use of pensions is to benefit from tax relief, and when using pension wrappers, a taxpayer can receive 20%, 40% or even 45% instant tax relief (!) which is far better than any investment return you will ever get.

To be able to decide what and how to use them, you first need to understand them. There are two main types of pension:

Defined Benefit (DB) – E.g. MOD pension, Teachers pension, NHS pension scheme and all final and career average salary schemes – with a DB scheme there is no investment risk and you will receive a set level of income which is guaranteed for life. DONE.

I’m not going to go into Defined benefit scheme pensions too much as 1) I’m not qualified to and 2) I don’t need to – they aren’t flexible, and they do what you need them to.

If you have a DB pension you are likely to not have much control over it. Every year you should receive an annual statement which will show you how much you should expect and from what age. In simple terms, the figure is calculated based on how long you were a member of the scheme for, and your salary at the date of leaving. But don’t be fooled - these are far from simple schemes!

If you want to retire before the scheme retirement date you will also need to have additional provisions in place to cover the difference, be it a DC scheme explained below or other investments, such as an ISA.

Defined contribution (DC) – E.g. Auto enrolment schemes and most private sector schemes. These are essentially a big pot of money, which hopefully your boss and you have paid into for your entire life. The best way to understand them is in a diagram.

The box represents a DC pension pot and whilst the money remains in a pension wrapper, it is protected against: capital gains tax (CGT), income tax on interest, dividend tax on share profit and most importantly but also unknown – Inheritance Tax! Pensions wrappers also allow individuals to take 25% from their pension, tax -free!  

Due to Inheritance Tax alone, you should never consider taking money from your pension unless you are going to spend it.

To explain this a little more I will use an example:

You are 68 and you take £100,000 from your pension as a lump sum for one reason or another after you have already taken your tax-free amount. You pay tax on the £100,000 as if it was income; even if you had no other earnings in the year you would pay over £17,000 in tax. You then sadly pass away a month later without spending the remaining balance. The £82,000 odd could then be liable to Inheritance Tax at 40%, meaning your beneficiary would receive under £49,000 and HMRC would receive in tax receipts anything in the region of £50,000!

That is best case scenario, I’ve seen far worse examples.

However, if you had left it in the pension and only drawn what is needed, your beneficiary would have received the entire £100,000 with NO tax liability whatsoever.

As a side note, pensions are much more protected than they used to be. The Financial Conduct Authority (FCA), Treasury and The Pensions Regulator (TPR) have all worked tirelessly on protecting you and your retirement fund. If you aren’t sure about your pension, do some research and due diligence - don’t just sit there - and definitely don’t listen to Bob in the pub who gives opinions on out-of-date information he got given in the 90s. (sorry Bob).

Pensions have unique tax benefits meaning they are an essential tool that should be utilised by EVERYONE. As I’ve already mentioned pensions have a lot of benefits. These include: no IHT liability on death, no capital gains tax on capital growth inside the pension, no income tax on interest received on investments inside the pension and no dividend tax on share distribution on shares held inside the pension. Essentially, pensions are fully tax efficient. Also, don’t forget money paid into pensions receive tax relief at the payee’s income tax rate. Meaning basic rate taxpayers receive 20% tax relief on pension payments, higher rate taxpayers receive 40% and so on.

Did you know?... Even if you do not pay tax, you can still pay in £2,880 per annum and receive basic rate tax relief of 20%! Winner!

Ok, so in a little more detail DC schemes are all pots of invested money, but there are different types. There are then 3 main types and you need to understand the differences before you can select which one works best for you:

1.      Personal pension (PP) – Group Personal pensions (GPP) and stakeholder personal pensions also come under this

2.      Self-invested personal pension (SIPP)

3.      Small self-administered scheme (SSAS)

So, of the 3 different pensions above, what is the difference?

The normal person just wants a personal pension, and my advice is to not over complicate an already complicated product.

SIPP’s and SSAS’ open the door to further options including lending and property purchase, and to the normal person many unneeded ‘bells and whistles’ that you have to pay for. I wouldn’t open a SIPP or SSAS without advice and I would also be wary of companies offering you such products. If this is their only pension option and you really want to use them, then just be careful and I would always seek financial advice as SIPP’s can allow access to investments which are unregulated and therefor a lot riskier. (my thoughts are SIPP’s are likely to be the next major mis-selling scandal since PPI!)

I won’t to go into detail on SIPPs and SSAS but suffice to say, if you’re unsure you should seek financial advice.

All DC schemes have the same limits placed upon them by the UK government which include:

-         An annual limit to money paid in - £40,000 or taxable earnings (whichever is less). The annual allowance can be carried back for 3 years as long as there are sufficient earnings in the tax year the contribution is being made.

-         If no earnings in a tax year, £3,600 gross can be paid into pensions.

-         Lifetime allowance (LTA) of £1,073,000, (increasing in line with inflation annually) - the lifetime allowance you need to be careful of if you are close. This is because investment return may take you over the limit and the increase in line with inflation could be too small to counteract the investment returns.

As a final point on pensions, they are ever changing, and ever evolving. Something I read in one of my advance pension exams put it perfectly: “somebody who waits for a stable pension framework before starting their retirement provision will probably never start making provision”. This just epitomises pensions and how industry professionals view them. They aren’t perfect and expect changes, but they are progressively getting better and better.

Alternative Tax wrappers for retirement planning

I’ve mentioned previously that if you want to retire pre 55 you can’t use pensions for ALL of it, and the gap between when you want to retire and 55 needs to be filled with an alternative measure.

So, what are your options if you want to stop work at 50? (Please note there are many more options should you be forced to stop work early through ill health or injury.)

Tax wrappers themselves are essentially a title for an account. That pot is then protected by the individual tax wrappers unique taxation. If you do not use a tax wrapper to save or invest, the pot could be liable to some or ALL taxes.

Examples of different tax wrappers are:

-         Pensions – Personal pensions, Self-invested personal pensions (SIPP), small self-administered scheme (SSAS) - I’ve covered these earlier in the segment.

-         ISA’s – (individual savings accounts), cash ISA’s, Stocks and Shares ISA’s, Junior ISA, Lifetime ISA and help to buy ISA

-         Bonds – Onshore or Offshore

I will start with ISA’s. I am not going to go into the many different ISA products as they are well documented in the market as to what each type does and outside of the scope for this article. But, for retirement you will either need a stocks and shares, cash or Lifetime ISA. ISA’s as a whole, provide tax free growth meaning they have; no income tax, no capital gains tax and no dividend tax liabilities on assets held. They are however liable to inheritance tax, which means they form part of your estate on death, which is why pensions are favoured for financial planning over ISA’s.

The current limit for Stocks and Shares and Cash ISA’s is £20,000 for 2020/21 tax year, and £4,000 of that can be paid into LISA’s.

ISA’s are great for growing your money, but the lack of tax relief on deposits into the ISA and lack of protection from IHT means anyone with IHT issues or income tax liabilities need to look elsewhere for greater options.

With bonds, the tax is different when it is either located (denominated) in the UK (onshore) and then when it is not (offshore), for instance in the Isle of Man or Ireland.

I would suggest if you don’t already know about these then do not touch them without first consulting a financial adviser as 1) you probably do not need to and 2) it is likely you could slip up tax wise.

With all the different wrapper types, you are in control of what is inside the ‘pot’, the same as if it were a pension. It can be 100% invested in cash, it could be 100% invested in high risk investments, or any balance in between.

A lot of the people offering investable tax wrappers (pensions and S&S ISA’s) will offer a default asset allocation and fund selection so most people will leave it in that default selection – which generally speaking is a bad move. Default funds tend to be ‘one size fits’ all and hopefully if you take one thing away from this set of articles it would be: ‘one size in retirement NEVER fits everyone’. So, take the time to either research your investments or pay someone to do it for you.

Some other options for funding retirement which have become more popular in recent times is the use of residential property.

This can either be by:

·        Buying property outright as a second home and renting it out. This comes with a lot of administration burden, but you will also benefit from any capital increases in the market. The drawbacks of this method are many; as above the administration, but also the capital gains tax on the gain and you will definitely need to be aware of IHT rules when owning more than one property as you will be much more likely be towards the top of the IHT band.

·        The other option when using property would be an Equity Release Mortgage. This entails releasing the already owned equity from a property to fund retirement; the equity which was released would then be paid off once you pass away on sale of the property. As advisers we plan as much as possible to not have to rely on this as the risks and costs usually outweigh the benefit.

The final alternative to using either pensions, tax wrappers or property for retirement is the use of private company equity.

This option would be for company owners who have, over your career built up a company to a stage where it is your largest asset.

If this is the case, you could either:

Keep the company going, putting people in place to allow you to step back leaving them running the business and receive income by way of distribution of profit from your shares in the company as your income in retirement.

Or

Sell the company, pay capital gains tax on the sale profit and use that capital sum to live off in retirement, either by placing it in investments or leaving it in cash.

Both above options have pro’s and con’s and would largely depend on your individual preferences and circumstances at the time. One thing I would mention though is as advisers we would never advise holding one company as your only investment unless you are in full control of that company. Once you deploy a management team into the company, no matter how much you trust them, they are now in control of your life and your retirement. If they run the company badly you could end up with a largely reduced income or as a worst case, without an income in retirement.

Something to keep in mind for both property and business equity would be the tax treatment. Both are taxable, both on growth and income but then also on disposal. They are also both included in your IHT calculation. You should ensure you fully understand the option you decide to take and the negatives you will need to prepare for. If you decide on this route as your main source of income in retirement, I would definitely recommend you speaking with both your accountant and a financial adviser to ensure it is the best route for you. This wouldn’t be to try and convince you to do something else instead - it would be to adjust things in your pension or other provisions to help protect against the worst.

Told you it was long! Thanks for making it to the end, next up in Stage 5 is everything you should know, no matter the stage of life you are at, it’s another really interesting one so stay tuned!