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Pensions suddenly become very interesting

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Friday April 4, 2014 at 12:23pm
Changes announced in the budget mean you could turn a £10,000 investment into £18,333 simply by using tax efficient pension investments. Let me explain.

It used to be that you invested in a pension during your working life and then bought an income for life in the form of an annuity. There are two problems with annuities; firstly they work by the people who live longest being subsidised by those who die earliest. Many see this as grossly unfair, in effect a stranger is benefiting from the bad luck of their death when people would rather their children benefit from what is left in their pension pot when they die.

Secondly the rate an annuity pays, after what are often non transparent charges, is linked to medium term interest rates. With these at historic lows annuities now pay very little. An index linked annuity can pay less than 3% income so a £500,000 pension fund pays less than £15,000 income for life.

The alternative to buying an annuity is to go into pension draw down. This means leaving your pension invested and taking an income from the pension pot each year. In the recent budget the Government announced that from 2015 people will be allowed to take whatever they wish from their pension. The first 25% will be tax free, as now, with the remainder taxed at their marginal tax rate.

It struck me that if you were anywhere near age 55, which is the age from which you can take pension (whether you retire or not) why would you save money in any other way. If you are a 40% tax payer and you invest £10,000 in the building society any growth is taxed at 40% and crucially there is no tax relief on the investment. If the investment grows at 10% after 1 year the investment is worth £10,000 plus £600 interest (after tax) total £10,600.

Take the same £10,000 investment into pension, tax relief of 40% means that £16,667 is the value of your investment simply due to the tax relief received. If this grows at 10% the total becomes £18,333. If you then withdraw all of this from pension and then reinvest in EIS, which gives 30% tax relief the figures look like this. £18,333 invested with £5,499 tax relief which incidentally matches the tax you would have paid on the non-tax free cash part of your pension withdrawal. Keep it there for 3 years and you get to keep the full £18,333 plus any tax free growth on the EIS investment. Compare that to the building society alternative.

The reason this works so well is because the bulk of the growth in the investment is provided by tax relief rather than investment returns. This is a much lower risk way of investing and if the new rules do become law in 2015 this will bring significant tax benefits to our clients.

I should add that EIS (Enterprise Investment Scheme) investments can be high risk and so you do need to choose your investment very carefully. So don’t do this without taking advice from preferably a Chartered Financial Planner.

Andy Parker

Chartered Financial Planner, Solihull

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Parker Chartered Accountants and Financial Advisors is the trading name for Parker Business Development Ltd (Registered No. 4116664), Parker Tax and Trust Ltd (Registered No. 06950353) and Parker Financial Planning LLP (Registered No. OC347027). Parker Financial Planning LLP is authorised and regulated by the Financial Conduct Authority. All companies are registered in England and Wales – registered office contact details here