Prudential’s Head of Technical Les Cameron analyses ways paraplanners can use tax allowances and exemptions to the benefit of clients.
I like my rugby so was watching the Autumn Nations Cup. And thoroughly enjoyed it I did too (well the parts where the ball wasn’t in the air that is).
I also coach at my local rugby club so watching the ANC was also a bit of a busman’s holiday looking out for moves and strategies that could potentially be introduced to my team’s play.
What I wasn’t expecting was inspiration for the day job too!
You will often hear the referee yelling “use it, use it” to the scrum half meaning if he doesn’t pass the ball he is going to lose it. The ball is invariably “used”.
This made me muse on whether this would be a good idea for financial planners too.
You might have already concluded where I was going with this tortured analogy. But I had a little smile imagining planners yelling at clients to “use it, use it”, when it came to their various allowances and exemptions at tax year end. Before 6 April ticks around and they lose them!
It’s relatively standard stuff but let’s think about what’s there to use that you might not want to lose.
Personal allowance
Most people have £12,500 of income that they can receive tax free.
As an annual allowance anything not used is lost. It may not be pertinent for a lot of people but if there is personal allowance left that is not necessarily going to be available in future tax years then any taxable withdrawals already planned may be best brought forward.
Alternatively, where ISA allowances are not being utilised then withdrawing what is normally taxable income and using that to fund the ISA will allow that money to be withdrawn tax exempt so maximising the use of available personal allowances. For example, if only £10,000 has been drawn in pension income making that up to £12,500 and using the £2,500 in an ISA will allow next year’s allowance to be taken as well as the £2,500.
IHT considerations may well come into play for some. Which brings me to…
Annual Exempt Amount – IHT
An individual has an annual exemption for lifetime transfers of £3,000 per tax year. After making use of your current year’s exemption, you can also carry forward any unused amount from the previous tax year.
For larger estates, £3,000 pounds is not going to make a serious dent in your IHT liability and some larger lump sum gifts may be the way to go.
However, the cumulative effect is worth it. Each use saves £1,200 in IHT. So over ten years it’s the difference between giving your family £30,000 or £18,000. Double those numbers if it’s joint planning with a couple.
Given the ability to carry forward this means a couple could give away £12,000 that had it otherwise been liable to IHT was carrying a £4,800 tax liability.
Use it often and benefit your family over HMRC. Areas of use? It could quite simply be a gift to someone else, used to waive outstanding loans in loan trust arrangements or used in conjunction with a larger gift.
A neat way to get a “tax turbo boost” would be to put it in someone else’s pension. Assuming they have earnings to support it, the £3,000 could be paid as a third party pension contribution. The government would top this up to £3,750 due to the basic rate relief at source. If that person was a higher rate taxpayer a further £750 tax reduction could be claimed – remember not all children are young! There will obviously be some tax to pay when the pension is subsequently taken but the tax relief at outset is high. If a £3,000 gift saves £1,200 in IHT and receives tax relief of £1,500 that’s 90% “family” tax relief.
Annual Exempt Amount – CGT
Each year you can crystallise gains up to the annual exempt amount with no CGT to pay, this year it is £12,300. It should be remembered that where losses have been realised in the same tax year these offset any gains before the exempt amount.
Conversely, if there are no gains crystallised in a year this could be a good time to consolidate losses as the full amount will be available to carry forward and offset against gains in future years. Any losses up to 25% could be recovered through the tax relief received by reinvestment in a pension.
Where assets subject to CGT on disposal are to be held until death then there’s no need to worry about using your annual exempt amount as, currently, the CGT uplift on death means that your gain effectively dies with you. Holding assets until death is probably not the norm in these days of investment management, risk managed portfolios and portfolio balancing etc. So it is, and always has been, good practice to ensure that the annual exempt amount is used each year by crystallising just enough gains to ensure they are tax free.
If gains (or losses) are crystallised then the key question is where should that money be reinvested. “Bed and Breakfast” rules mean the same holdings cannot be repurchased within 30 days.
Repurchase within 30 days is only available where the spouse buys the investment, or it is repurchased indirectly through a tax wrapper. Given the wide availability of open architecture tax wrappers then the question is perhaps which tax wrapper should be used to repurchase the holding? If the ISA allowance (and/or the spouses allowance) has not been used then this would seem to be a natural choice.
However, for older clients or those not needing access until retirement, then reinvestment in pensions with its tax relief advantages makes sense. £20,000 in an ISA leaves £20,000 invested, £20,000 in a pension, subject to earnings etc of course, leaves £25,000 invested and the potential for higher rate relief too. On exit within basic rate tax the pension nets £21,250 or in investment terms a net return of 6.25%. Potentially on cash! The higher the initial tax relief the higher the return would be.
Where gains are becoming unmanageable, the investment income is not required and is dampening growth or if there is a plan to do some estate planning in future then the repurchase of the investment within an onshore or offshore insurance bond wrapper may prove beneficial.
ISA allowance
In tax terms a veritable “no brainer” for many. Tax exempt growth and tax exempt withdrawals mean this will be the first port of call for many with new money to invest. Where new money is not available then it would seem sensible to consider any other less tax efficient investments and whether they could be encashed to generate the funds to allow the use of the ISA allowance. Clearly any tax impact or penalties on encashment would form part of the overall analysis.
Obviously, the allure of pension tax relief may see some direct disposable income toward the pension wrapper. Alternatively, given there is no IHT advantage on death unless the ISA holds business relief qualifying investments, then alternative solutions will be sought by those with IHT planning at the forefront of their mind.
Annual Allowance
The standard annual allowance for pensions is £40,000 but can be lower if benefits have been accessed, or if an individual is or has been a high earner.
Once the existing years annual allowance has been used up, carry forward can be used to make additional contributions without a tax charge arising. Any unused annual allowance can be carried forward for up to three years so, when 6 April 2021 comes around, any unused allowance from 2017/2018 will be lost unless it is used up. Maximising pension funding is generally sensible for most so maximising the use of available allowances should always be considered.
Annual Allowance is useful but remember in order to make use of it you must first have the relevant earnings to support a contribution (unless the employer is paying).
Relevant Earnings
Clearly relevant earnings are not an exemption or an allowance but the same principles apply. Long gone are the days when you could carry forward any unused relief from the previous six years.
These days you can only use the relevant earnings in the year they are made.
There are three things to consider here.
One, have earnings spiked this year? This could be through redundancy, a larger than normal bonus or perhaps a bond encashment has been made. This will generate a tax liability which can be avoided by making a pension contribution before tax year end year.
Two, have you entered a tax trap? The child benefit and personal allowance tax traps kick in at adjusted net income over £50,000 and £100,000 respectively. Pension contributions reduce the adjusted net income which also returns higher than marginal rate tax relief. And as explained above the higher the tax relief the higher the “net return”.
Three, is this the last year relevant earnings will exist? For those retiring early in the new tax year their ability to fund pensions will be severely restricted by the absence of relevant earnings. So, funding should be maxed out before these earnings disappear.
100% of earnings is allowed as a contribution. But as people need to eat and live it’s unlikely they can use all their earnings to “max out”. You could of course use existing capital to pay 100% of earnings, effectively meaning you are a non-tax payer in the year before you retired. Doesn’t that sound nice?
And if people do have capital to support larger pension contributions should you make most of the relevant earnings you do have in the run up to retirement? Would it be nice to be a non-tax payer in the years leading up to retirement, or perhaps wiping out your higher rate liabilities, just by moving your non pension capital into your pension as retirement approaches?
In summary
To put the finishing touch to my tortured analogy from rugby. Building a good rugby team the coach has to pick some tall guys for second row and some fast guys to play in the back three. Different players are needed for different positions.
Likewise not all strategies will be correct for all clients. The paraplanner and adviser have to make sure they choose the right allowances and exemptions to come into play for team client.
