There is a new pension regime in place for the 2015/2016 tax year which enables savers over the age of 55 to have full access to their money. While this is a fabulous opportunity, it is also a major risk. There are also new tax rules in place; the most important one involves allowing you to pass on your pension assets outside of your estate for the purpose of inheritance tax. If you are a wealthy investor, you now have the chance to avoid this hated tax without facing any legal issues.
Obviously, the way to do this will vary depending on your individual circumstances but if you have a pension (where the total assets may surpass the existing £325,000 inheritance tax threshold for a single person and £650,000 for a married couple) and follow the below 6 steps, you can significantly reduce the impact of this tax paid by your beneficiaries simply by prioritising your spending and rearranging your assets.
1 – Fill Up Your Pension As Much As Possible
Pension contributions get tax relief when being put in and then benefit from tax free gains while inside. It also allows you more investment options than the ISA including commercial properties. The maximum amount you can put in depends on your income but is capped at £40,000 a year in any case. However, it is possible to combine several years’ worth of allowances in a year if have enough cash to make these contributions.
According to certified financial planner David Smith, it is possible to push ISA savings into your pension. He says that since pension contributions can receive 20-40% tax relief, an increasing number of people will begin selling ISAs and other savings. For example, if you surrender £8,000 worth of unit trusts in order to make a pension payment, £10,000 would be invested in total. If you are a higher rate taxpayer then you can use your tax return to claim an extra 20% of tax relief.
2 – Beware The Lifetime Allowance
The existing limit for pension assets in a lifetime is £1.25m and it will drop to £1m for the 2016/2017 tax year. It is important to remember that the limit relates to the value of your savings as opposed to the amount you actually put in. Consequently, you need to be careful and watch the growth of your investments.
Once you exceed these limits you will be taxed at 55% so the ultimate goal is to get as close to the threshold as possible without going over and getting penalised with extra tax. According to Lucy Brennan of Saffery Champness, a 50 year old with £500,000 in their pension receiving an annual return of 6% could have up to £2.1m in their pot after 25 years even if no more money is put in. Assuming the new £1m limit remains once it is in place, that saver would be heavily taxed. Of course, some people believe the tax charge is a worthwhile payment for the tax free uplift received in the pension along with having the ability to pass it on to loved ones.
3 – Make Sure You Have Enough To Live On
You should be looking to minimise the amount of non-pension assets you have above the existing death tax threshold of £650,000. The goal is for you to leave the pension untouched so you can give it to your heirs while you live on taxable assets. You will improve your inheritance tax position if you withdraw as little as possible from your pension.
Retirees are using non-pension assets such as savings and ISA accounts to live on while others are using property wealth with downsizing, equity release and buy to-let in order to generate income they can live on. Equity release allows you to raise cash from your home but it is important to note that compound interest on this loan may actually be higher than the savings you make on tax.
4 – Consider Giving Away Your Assets
Once you have a large pension and a significant amount of non-pension savings, you can cut tax by giving away some assets. There is an annual £3,000 gift exemption which is the minimum you should use if you go down this path. This is the maximum amount you can give someone without running into inheritance tax issues. Once you go beyond this limit, the gift can only fall outside your estate for death tax purposes if you survive for 7+ years after giving the gift. Make a record of these gifts to ensure the executor of your estate can take them into account after your death.
5 – Look At Inheritance Tax-Proof Investments
If you would rather not give away any assets, consider investing in shares such as those listed on the junior AIM market because they are free of inheritance tax. Along with certain other shares, they are the product of a government scheme to promote funding for business. On the downside, these are typically high-risk investments so there is a chance you’ll lose more than what you would pay in inheritance tax.
A less risky alternative is to take out a whole-of-life insurance policy which can help pay the tax when you die; this enables you to retain ownership of your assets.
6 – Create a Will
The trustees of a pension scheme will be responsible for distributing the assets and a ‘letter of wishes’ should be given to the relevant parties. Above all, make sure you take your time when writing your Will to reduce the chances of it being contested.