Approaching LSA - pension still the most tax efficient way to invest?

zagfles

ukdw said:

Once you hit the LSA then I think any additional pension contributions and growth in those contributions is likely to be charged 40%,60% or 45% tax on drawdown, 

If you get 40% tax relief on the way in then fairly neutral on fund withdrawal from pensions for withdrawal up to £50k above the basic rate per year. Growth also likely to be taxed at the same rates on drawdown.

If you get 20% tax relief on the way in - then less favourable - if withdrawals charged at least 40%.

Comparing above to leaving funds tax unwrapped - I think it currently looks like the following:

Original funds no more tax to pay.
Capital Gains - assuming they are for a higher rate tax payer -  24%
Dividends - 33.75%
Cash interest - 42%
So other than cash interest it looks like a slightly lower rate of tax on the gains than if funds put in the pension and taken out again.
With more flexibility on accessing the original funds without triggering 60% or 45% tax rates.

Also these rates on gains would have some annual allowances and could gradually be mitigated by rolling funds into ISAs each year.

Also if one of the couple is still in basic rate after pension withdrawals then lower rates on the gains in their name could apply.

You're making the same mistake as EdSwippet. See my earlier post. 

Triumph13

After wrestling with these kind of puzzles for years, trying to model LTA tax charges and lord knows what else, the most important advice I can give you is not to expend to much mental energy on trying to find the perfect answer.  It can't be done, thanks to all the inherent uncertainty, and in your case it simply isn't worth the stress.

You are fretting about tiny differences in the tax treatment of £50k that may leave the charities who inherit your estate a couple of grand up or down depending on how investments perform, inflation and future tax rules.  You have more than £2m to fund your retirement, plus SPs and DBs.  In the face of that, it simply isn't worth worrying about this last tiny bit of pension optimisation.  Just pick whatever's easiest and go out and have fun.

Alexland

MallyGirl said:

This is where Mr Mally is but he has the added factor that he gets the employer NI with his Sal sac. For now that swings the balance towards continuing max contributions. I am still hoping that he follows me into retirement in 2026

Aah yes that would still be worth it - he might be tempted to continue that until March 2029.

YellowCarBlueCar

Triumph13 said:

After wrestling with these kind of puzzles for years, trying to model LTA tax charges and lord knows what else, the most important advice I can give you is not to expend to much mental energy on trying to find the perfect answer.  It can't be done, thanks to all the inherent uncertainty, and in your case it simply isn't worth the stress.

You are fretting about tiny differences in the tax treatment of £50k that may leave the charities who inherit your estate a couple of grand up or down depending on how investments perform, inflation and future tax rules.  You have more than £2m to fund your retirement, plus SPs and DBs.  In the face of that, it simply isn't worth worrying about this last tiny bit of pension optimisation.  Just pick whatever's easiest and go out and have fun.

Thanks - and to all the other responses.
I know you're right - and I'm not so much fretting over the perfect optimisation but as I said before, my engineering mindset isn't great at making decisions without understanding the context properly.  At the same time engineers are set apart from mathematicians by a 'close enough for all practical purposes' approach - and I think I've reached that point.

This thread has provided a few really helpful practical pointers though:
-20% relief in with 40% tax out isn't compensated by tax-free growth in the pension in most cases.  So as I've already sacrificed enough this FY to take me into the 20% bracket I'll switch to the level that I receive maximum matched contributions.
-The ability to buy an annuity without a 25% matching tax-free withdrawal is an option (now or later).  Attractive for de-risking anyway, and can mop-up the chunk above the old LTA, so no LSA issue.
-I've looked into Gilts, but at the moment returns are broadly equivalent to bank interest rates (while a lower rate or non tax payer) which will be my position for a few years.
-I need to set up a GIA, partly for the money that would have gone into pensions, partly to make the portfolio less cash-heavy.

GenX0212

zagfles said:

EdSwippet said:

YellowCarBlueCar said:

So I'm struggling with whether the tax-free growth in the pension outweighs the income tax on withdrawal.

As already stated above, where the tax rates are the same the results are identical, because at 10% gains (say), 80% of 110% of £x is the same as 110% of 80% of £x.

The better question is whether tax-deferred growth in the pension beats annually taxable growth outside. Because here the tax rates can be different; specifically, dividends and capital gains have lower tax rates than income from a pension.

Taking a simple (and unrealistic) case. Suppose investments gain 7% over one year, 4% capital gain and 3% from dividends. On £70 of gain outside a pension, at basic rate tax you would pay 8.75% of £30 and 18% of £40 for £9.83 in tax. On £70 of gain inside a pension, 20% is £14 in tax on withdrawal. Investing outside the pension wins.

However, the annual tax outside the pension is a drag on compounding, which is tax-deferred inside the pension. This means there's a break-even point where the pension can start to win. So now the decision rests on how long you can leave this money inside the pension to compound.

And this is where things get tricky. Now you have to start modelling the future with spreadsheets or similar. There are multiple tax rates to consider, some of which may change, and usually not to your advantage, multiple inflexion points or other life changes, and also multiple assumptions about future growth, so that the possible outcomes branch ferociously.

For what it's worth, when I did this for my own case (back when the 25% LTA penalty was still a thing), I found my break-even on leaving my PCLS inside the pension compared to taking it now and reinvesting outside was likely to be around age 95. While this is technically a "win", it isn't a useful one.

This is completely wrong logic. You need to account for the growth on the tax relief element, £1000 invested in a pension would be £1250 assuming 20% tax relief. The extra income tax on growth is partly tax on the tax relief amount, which you wouldn't have outside the pension. So despite paying more tax, the pension will always be better assuming tax relief on the way in is the same as tax rate on withdrawal. 

For instance assuming your 7% growth of which 4% capital gain and 3% dividends. £1000 paid into a pension would be £1250, and growth would be £87.50, and on withdrawal would be £70 after BR tax. Outside the pension, that £70 growth would be £60.17 after tax. So despite paying more tax using the pension, you're better off. Because the extra £17.50 tax is tax on the growth of money you wouldn't have had outside the pension. So effectively the growth in the pension is tax free. 

Also not forgetting that Dividend Tax rates are going up to 10.75% (and 35.75% Higher rate) from April next year.

MallyGirl

Alexland said:

MallyGirl said:

This is where Mr Mally is but he has the added factor that he gets the employer NI with his Sal sac. For now that swings the balance towards continuing max contributions. I am still hoping that he follows me into retirement in 2026

Aah yes that would still be worth it - he might be tempted to continue that until March 2029.

Not if he wants a wants a harmonious home life 😀

af1963

Coming back to the IHT/charity question which you answered ...

As it seems that the money that's *already* in your pension is more than enough for what you're likely to need, anything you add now is money that will most likely eventually be going to charity.  So it's a question of how you want to do that.

Taking £800 of cash today, you could keep it out of the pension and gift aid it to chosen charities right now, turning it into £1000 (and maybe even see it being used immediately)

Or if you want to hold onto it 'just in case' you need it, you can put it into the pension, tax relief will upgrade it to £1000 (it may grow further inside the pension, tax free) and then you can take it out later (taxable, as your existing pension savings uses up the lifetime allowance) and gift aid the resulting £800 later.  If you take it out and pay 40% tax, you can effectively get that back using gift aid too.

Or if you never end up taking it out, the £1000 in the pension can be left to the charities after you're both gone.  (There are complications/ potential tax charges if you leave pension money to charities while there is a living dependent, but would be OK on second death.)  It doesn't matter that you go above the LSA in this case as the charities that receive the extra money won't be paying tax on it.

michaels

YellowCarBlueCar said:

Triumph13 said:

After wrestling with these kind of puzzles for years, trying to model LTA tax charges and lord knows what else, the most important advice I can give you is not to expend to much mental energy on trying to find the perfect answer.  It can't be done, thanks to all the inherent uncertainty, and in your case it simply isn't worth the stress.

You are fretting about tiny differences in the tax treatment of £50k that may leave the charities who inherit your estate a couple of grand up or down depending on how investments perform, inflation and future tax rules.  You have more than £2m to fund your retirement, plus SPs and DBs.  In the face of that, it simply isn't worth worrying about this last tiny bit of pension optimisation.  Just pick whatever's easiest and go out and have fun.

Thanks - and to all the other responses.
I know you're right - and I'm not so much fretting over the perfect optimisation but as I said before, my engineering mindset isn't great at making decisions without understanding the context properly.  At the same time engineers are set apart from mathematicians by a 'close enough for all practical purposes' approach - and I think I've reached that point.

This thread has provided a few really helpful practical pointers though:
-20% relief in with 40% tax out isn't compensated by tax-free growth in the pension in most cases.  So as I've already sacrificed enough this FY to take me into the 20% bracket I'll switch to the level that I receive maximum matched contributions.
-The ability to buy an annuity without a 25% matching tax-free withdrawal is an option (now or later).  Attractive for de-risking anyway, and can mop-up the chunk above the old LTA, so no LSA issue.
-I've looked into Gilts, but at the moment returns are broadly equivalent to bank interest rates (while a lower rate or non tax payer) which will be my position for a few years.
-I need to set up a GIA, partly for the money that would have gone into pensions, partly to make the portfolio less cash-heavy.

Re the bit about being a lower rate tax or non tax payer. This makes no sense from age 55 when you can start drawing pension, why waste zero/20% tax band headroom now only to pay 40% later?

Albermarle

zagfles said:

Albermarle said:

One question on point 6.  If I keep my payments to the company pension to the minimum to get the max matched contribution, but then pay the rest of my annual allowance to the SIPP, then can I then use the SIPP to buy an annuity without taking any tax-free cash?  In that way the SIPP value would not 'consume' from my LTA.

The large majority of annuities, work by taking the pension pot, giving you the 25% tax free, and then the annuity is bought with the 75%.
You can then buy another much rarer type of annuity, which you buy with the cash, but that would not meet your objective
I am pretty sure you can not just buy an annuity though with 100% of the original pension pot. If you can it would be some kind of niche product you would have to go via an IFA, if it was possible at all.

In theory you can move 100% of a DC pot into drawdown, forgoing the tax free cash.
However apart from it normally not being a very good idea, most providers systems could just not cope with such an unusual request. Normally you move funds into drawdown, by requesting the tax free cash. That is how the systems work. 

What makes you think that? You can buy an annuity from a pot already in drawdown, plenty of people do that, crystallise and drawdown for a while, then buy an annuity when they're a bit older. So using an uncrystallised pot with no LSA left (or wanting to the use the LSA elsewhere) is perfectly possible. 

OK I might be wrong, but are you sure that if you approached an annuity provider and said I have a 100% uncrystallised pot, and I want you to use all of it to buy an annuity and not take 25% tax free, that they could do this? 
This would be an unusual request, and maybe it would be case of 'the computer says no' ?
Or maybe it would have go via an IFA as it was non standard?

QrizB

Albermarle said:

OK I might be wrong, but are you sure that if you approached an annuity provider and said I have a 100% uncrystallised pot, and I want you to use all of it to buy an annuity and not take 25% tax free, that they could do this? 
This would be an unusual request, and maybe it would be case of 'the computer says no' ?

On the Hargreaves Lansdown annuity tool, you tell them what % of TFLS you want. The implication being that you don't have to take it if you don't want it.

If something as mainstream and novice-friendly as the HL tool offers this, it might at least suggest that this isn't a particularly unusual option to take?