Pension tax?

jamesd

EdInvestor wrote: »

Withdrawals from capital increase risk of losses during market downturns.

What really happens is that the investment growth and income is added and you can take 5% a year of the original investment amount as income without additional tax to pay on it because it's treated as if it was returning some of the original capital.

It's like a savings account that pays 5% interest and is set up to pay that interest into another savings account. Then a standing order to pay 5% from the first savings account is set up. The first account may drop by 5% but the second savings account is growing by the same 5%. Twenty years later the first account is empty but the second one has all of the capital in it because the 5% amounts were accumulating in it and not being touched. Just like going to a bank and asking to swap one five Pound note for another. It's still five Pounds even though it's not the same five Pounds you started out with.

There's no additional risk of loss due to market downturns because of this accounting trick that gets better tax treatment. All you need to do is not take out more than the investment makes, just like any other way of getting an income from investments.

Newly_retired

Great explanation. Thanks for that.

EdInvestor

jamesd wrote: »

It's like a savings account that pays 5% interest and is set up to pay that interest into another savings account. Then a standing order to pay 5% from the first savings account is set up. The first account may drop by 5% but the second savings account is growing by the same 5%.

Except that it isn't, because it's being withdrawn to spend.

Twenty years later the first account is empty but the second one has all of the capital in it because the 5% amounts were accumulating in it and not being touched.

Except that they were not accumulating, they were being taken as "income".

dunstonh

Except that it isn't, because it's being withdrawn to spend.

Ed's scenario is that you take the dividends rather than have them reinvested. The other scenerio is that the dividends are reinvested and you take a withdrawal from capital.

If you have dividends of 5% and they are paid out then the end result is the same as having the dividends reinvested and drawing out 5%. The only difference is tax.

The bond can have advantages with fixed interest/high yielding funds as the taxation basically no different on income to that of a unit trust. So, by taking a withdrawal of capital from the bond you do not have to declare it as income for tax purposes if you take 5% or less.

The groups that can see an advantage are:

1 - over 65s who are close to the age allowance reduction threshold. Income from unit trusts (or interest) could take you through this and create nearly £1000 tax liability per year. A bond would not.
2 - those who are close to the higher rate limit would not be made higher rate taxpayer by using the bond and can use the top slicing tax relief to their advantage.
3 - higher rate taxpayers now who will be basic rate or lower later on. You dont pay higher rate tax on the investments and you hold on to them until you are basic rate and then create a chargeable gain then (or staggered over a couple of years if necessary) to avoid higher rate.
4 - Investment bonds are not included in the means test for local authority care unless you use them for income generation (and you didnt invest them when you knew care was due).
5 - investment bonds are not included in the means test for pension credit or other means tested benefits.
6 - estate planning. Investment bonds can be placed in trust.

Modern bonds are actually quite cheap and its now possible to buy bonds with no additional cost over unit trusts. You can also put unit trusts inside the bond as well.

Recent tax changes have made investment bonds more favourable for holding fixed interest funds than equity funds. So, they do tend to be more suited to the retired (or soon to be retired) individual.

When used at the right time, the investment bond can be a very useful and very efficient tax wrapper. However, they do tend to be oversold by lower skilled advisers and tied agents when unit trusts would be better. So, you need to be on guard and if a bond is recommended, you should make sure an analysis of bond vs unit trust has taken place (it should be in the suitability report as possible alternative options should be documented as to why they were not done).

Some people are a bit narrow minded and blame the product and are negative against it even when its best advice.

jamesd

EdInvestor wrote: »

Except that it isn't, because it's being withdrawn to spend.

The standing order from the first "starting capital" account is the income being taken to spend. The investment gains (dividends, share value growth, whatever else) are what is being paid into the second account.

The balance in the first account will fall but that doesn't matter. All that matters is that the amount going into the second account is as much as is being taken out by the standing order.

You end up with "different" money in the second account but that's irrelevant. It's just a tax-efficient accounting trick, not actual loss of capital.

EdInvestor

jamesd wrote: »

The balance in the first account will fall but that doesn't matter. All that matters is that the amount going into the second account is as much as is being taken out by the standing order.

But it isn't is it? Before recording earnings of say 5% for a cautiously invested bond, equal to the 5% being withdrawn to spend, you have to account for tax and charges.

1% will be deducted for tax. Fund AMCs will typically be 1.5%. Hidden transaction charges let's say 0.5%.Commission to non greedy IFA say 0.5%. Total 3.5%.So the net effect is that only 1.5% is going into the earnings account while 5% is being withdrawn from the capital account.

What happens if you make a loss of say 10% - typical in the past year ? That loss is actually 10% + tax and charges of 3.5%, so 13.5%. Add on 5% withdrawal from capital for spending and you are down 18.5%.

The other problem with cashing in assets to pay income is that when prices start recovering you will be starting from a much lower capital base. Whereas if you take dividends for your income, the number of shares you own remains the same, only their value fluctuates.

Say you have 100 shares in Lloyds Bank, which is paying a dividend of 5%. You take that 5% dividend for your income. Although the price of the shares may go down from say 10pounds to 5 pounds, reducing your capital from 1000 pounds to 500 pounds, when markets recover, your 100 shares are still intact and your capital will regain its value.

But say you do as the fund managers want you to do. Instead of taking the divis as your income (free of charges) you reinvest them (incurs transaction fees and stamp duty tax). You then cash in shares to pay your income (incurs more fees).The more the price falls, the more shares you have to cash in to pay your income.

So when the market recovers again, you will end up having paid lots more fees and with perhaps 75 Llloyds shares, whereas the person who took the divi income will have paid no fees, and will still have 100 Lloyds shares.

Both will have received the same 'income'. But one person's income (from the divis) has had no effect on his capital, while the other one's has.

Such is the way the financial services industry deprives you of your capital by stealth.

dunstonh

1% will be deducted for tax.

Your understanding of taxation of life funds is wrong Ed. You have been told this so many times yet you ignore it. (and its been 2 or 3 times this week alone).

Fund AMCs will typically be 1.5%.

Typically 1% for internal funds but higher for external. A unit trust version of the bond will be the same as unit trusts. A conventional version may have reduction in yields below 1% p.a. over a 10 year period.

Commission to non greedy IFA say 0.5%.

Payable out of the annual management charge and not in addition to (as you have it).

What happens if you make a loss of say 10% - typical in the past year ? That loss is actually 10% + tax and charges of 3.5%, so 13.5%. Add on 5% withdrawal from capital for spending and you are down 18.5%.

Ignoring the actual figures you use as they are wrong. However, how does that differ to any other tax wrapper. Its the same on pensions, unit trusts and ISAs

The other problem with cashing in assets to pay income is that when prices start recovering you will be starting from a much lower capital base. Whereas if you take dividends for your income, the number of shares you own remains the same, only their value fluctuates.

If the income on the bond is reinvested then drawing money as capital withdrawal makes no difference.

Say you have 100 shares in Lloyds Bank, which is paying a dividend of 5%. You take that 5% dividend for your income. Although the price of the shares may go down from say 10pounds to 5 pounds, reducing your capital from 1000 pounds to 500 pounds, when markets recover, your 100 shares are still intact and your capital will regain its value.

If you had LloydsTSB shares in the bond then the income would be paid back into the bond to buy more units or the price would be increased to take account the reinvestment of the dividends. So, drawing out the equivalent of the dividend gives the same result.

So when the market recovers again, you will end up having paid lots more fees and with perhaps 75 Llloyds shares, whereas the person who took the divi income will have paid no fees, and will still have 100 Lloyds shares.

The person that had income reinvested within the bond may have a lower number of units due to encashment. However, the unit price would be higher to reflect the income that was reinvested within the fund. That assumes a conventional life fund. However, it wouldnt apply to income life funds or unit trusts (income units) which are held in a bond. 12 x 8 = 96. 8x12 also equals 96.

Such is the way the financial services industry deprives you of your capital by stealth.

Only if you dont understand what you are talking about. Which on this subject, you have shown many times that you do not.

You dont undestand the taxation of life funds. You dont understand the charging options available. You dont understand the times when its suitable.

To be honest, I think you do understand it but choose to ignore it because you have been told so many times but continue to spout out the misinformation.

dunstonh

Just to clarify for taxation and why Ed is wrong when she says it is 20%, here is how investment bond taxation works:

A life office pays corporation tax on all gains within a life fund on an annual basis(which is where Ed gets the 20% starting figure from). The exact amount paid will vary depending on the fund’s composition but is taken to be equal to basic rate. Life offices retain the indexation allowance on capital gains, so are effectively not taxed on inflation. Life offices will continually accrue a portion of any gains from a fund throughout the year to cover the tax, in a falling market some of these tax reserves can be added back. So, that covers gains. However, tax on income is the same as for bonds as UTs. The investment house pays income tax at basic rate on behalf of investors; income classed as dividends is received net of the 10% dividend tax credit and interest paying assets are taxed at 20%. So, the net effect of taxation will be less than 20%. How much less will depend on the make up between income and growth and if the market is rising or falling.

In practice this means that if the underlying assets of a fund returned 10% growth (no income), a collective would increase by the full 10%. The same fund accessed through a bond would be taxed so the investment would increase by 8% (ignoring indexation allowance for this point). Over the course of several years this effect is compounded and the difference in overall return widens. In the reverse situation, a fund that returns 10% income (no growth) accessed through a bond would return the same as a collective - 8% if classed as interest and 9% if classed as dividend. In these simplified examples the collective produces more or the same as the bond.

The overall charges on a bond are often lower than on a collective, particularly in the longer term when establishment charges and exit penalties end and the effect of commission is reduced. This arises as collectives have more regulations and hence higher running costs. In particular there are costs required for the services of accountants, custodians and trustees etc.

Equity fund example:

NU Index tracker
Between 31/12/02 and 31/12/07 the unit trust version returned 93.3% compared to 73.5% on the life version (being mainly reliant on growth the gap is wider)
Between 31/12/99 and 31/12/02 the unit trust version returned -38% compared ot minus 29.7 on the life version. The tax being repaid back into the investment making the life fund better in the falling market.

If you take the period of the fall and recovery between 31/5/2002 and 31/5/2007 the unit trust version returned 54.4% and the life version 45.5%

So when the investment spread is heavy in equities, the unit trusts will appear better unless there are external taxation issues to influence that (such as age allowance). If you had a fund that was heavy in income, the differences would be negligible due to the near identical taxation on income within the investment.

So when looking at investing, you need to look at your portfolio make up (heavier in income or growth), personal taxation and charges to get a realistic idea of which option is best.