‘Could I save tax by investing what remains of my pension lump sum?'

Telegraph

5 days ago

Email your tax questions to Mike at: [e-mail] *
Dear Mike,
My wife and I are in our 60s and have been retired for several years. I get the full state pension, and we supplement this with monthly drawdown amounts from our Sipps (self-invested personal pensions). We have cash Isas, stocks and shares Isas, and Premium Bonds, which we use for holiday spending. We have no company pensions.
I have been looking for the most tax-efficient ways of accessing my Sipp funds, as all my personal allowance is used up by the state pension and all withdrawals (except the 25pc tax-free lump sum part) are subject to 20pc tax. I have about £100,000 left of my tax-free amount still to use.
One thing I am considering is taking the tax-free amount in one lump and placing it in a general investment account. I would invest in bond funds and dividend-paying shares and draw regular amounts from this pot, rather than from the Sipps.
These dividends would only attract tax at 8.75pc rather than 20pc, which is a considerable difference. There would also be capital gains tax to pay if I sold the holdings, but even that would become zero if held until death.
Am I missing something?
Best wishes,
Andy
Dear Andy,
You have understood and explained the rules correctly, and your question has helpfully prompted me to explain the process in more detail. Some of the background may help in this.
It was a happy coincidence that when the coalition government was formed in 2010, George Osborne was able to call on the services of the highly able Lib Dem MP, Sir Steve Webb, to become his pensions minister.
Between them they radically changed the pensions industry for the better with the introduction of the pension freedoms we enjoy today. Before the change, members of defined-contribution (DC) pension funds were forced to buy an annuity by the time they reached age 75, regardless of the state of the annuity market at the time. Many did so through their existing provider, often at poor rates.
Following the changes in 2014, members could choose for the fund to stay invested and take their pension in drawdown as and when needed. The choice of an annuity remained available to be taken in whole or part as and when market conditions were right. Some people spread their risk by taking part as guaranteed income through an annuity, with the rest in drawdown.
This is what I chose to do, using a quarter of the fund on a fixed rate annuity, although that was partly because that element arose from an old scheme which offered an annuity rate of 11pc, a relatively standard deal in 1987!
Pension freedoms inevitably involve making difficult choices. The government recognised this and increased the availability of appropriate advice.
I understand from your question that, so far, you have both taken a pension from your Sipps in drawdown, and it seems that you are doing so by including the 25pc tax-free allowed on a regular basis.
Technically, you are crystallising a part of your fund on each occasion. I do not know the actual amounts involved, but if you crystallised £400 each month, £100 would be tax-free and the balance would be drawn from the crystallised fund and subject to income tax, in your case at 20pc.
Your question is whether to keep to this arrangement or to take the whole of the remaining £100,000 tax-free amount available and invest it personally.
Keeping the £100,000 invested in the fund has allowed it to grow tax-free and thereby increase the tax-free element ultimately available. It has also ensured that this part of your wealth has been protected from inheritance tax.
However, the Chancellor has announced that from 2027 DC pension funds will be included as an asset in estates at death. In addition, I fear that in her current predicament, Rachel Reeves could either remove or limit the amount of cash that can be taken tax-free.
What you have described is essentially the same choice facing everybody with a DC pension fund at some stage and, as Pension Doctor Charlene Young recently found, people are considering different ways to try to minimise the effects.
There is no rule of thumb on the best plan because it depends on personal circumstances and the tax rates involved, and while your plan may sound good in theory, you should seek financial advice before making any big moves.
An example of where a large lump sum withdrawal could be beneficial is where one partner pays higher-rate tax on income from his or her pension scheme, and their spouse is a basic-rate or non-taxpayer. In a case like this, early access to the tax-free amount may make sense, with the assets passed to the lower-rate taxpayer. It also depends on the extent to which income received personally would be covered by the savings and dividend tax-free allowances.
I cannot miss the opportunity to comment on the recent statement by HMRC about how the new inheritance tax rules will be applied on estates which include DC pension schemes.
Some readers may disagree, but I see this as double taxation and a disincentive to save for retirement. It was immediately clear from the Budget last year that this policy would involve massive additional complexity with the need for executors, pension fund trustees and HMRC to exchange information to manage the inheritance tax and income tax liabilities involved.
Despite this, the Government has announced it is pressing ahead with the change. Not only that, but from the statement issued by HMRC it seems that it is the executors, rather than the pension fund managers, who will have to take responsibility for ensuring that the correct amount of tax is paid.
This involves a five-step process that executors will have to go through, with a tight timescale. They will have to contact the various pension managers concerned to establish details of the funds managed and the beneficiaries involved, which will apparently include making sure that these beneficiaries pay any tax due.
Acting as an executor is an unenviable task and this can only make matters worse. Executors are usually family members and close friends of the deceased who will be grieving for their loss at this time. It is bound to involve more professional advice, which will come at a cost ultimately on the beneficiaries.
Once again, I fear that this government has chosen to make a change for ideological reasons with insufficient consideration of the impact on those involved. Incidentally, this does not change my view that it is better for the executors to select their professional advisers, rather than having solicitors named as executors in the will.
– Mike
Mike Warburton was previously a tax director with accountants Grant Thornton and is now retired. His columns should not be taken as advice, or as a personal recommendation, but as a starting point for readers to undertake their own further research.