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Taking taxable income only from SIPP to maximise IHT protection

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Taking taxable income only from SIPP to maximise IHT protection

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caveman8006caveman8006 Forumite
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Say, for simplicity, that the LTA allowance is £1m with no indexation and you have exactly "landed" at that at age 60 via a combination of a £25k pa DB and a £500k SIPP. Also, you have a large ISA pot which, together with your DB pension and the investment returns from your SIPP (let's assume £25k pa), will be sufficient to cover your income needs for the rest of your lifetime. So, to maximise the IHT protection of your SIPP wrapper, you only wish to draw the investment returns from your SIPP as taxable income to avoid an eventual LTA charge at 75. What is the best way to manage the SIPP?


I have been told by AJ Bell/You Invest that they allow you to "crystalize" the SIPP into a "tax-free pot" and a "drawdown pot", but leave both invested and take income as required from either pot. So, in this case, would it be possible to crystalize the SIPP into £125k with a tax-free income and £375k with a taxable income and then draw £25k pa of taxable income from the latter each year and not be liable to an excess LTA tax at age 75? Indeed, if necessary, you could also take out up to £125k from the first pot in an emergence tax-free at any time, but if it was not needed, then the full £500k could be passed on, IHT free to children on death.
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  • EdSwippetEdSwippet Forumite
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    I have been told by AJ Bell/You Invest that they allow you to "crystalize" the SIPP into a "tax-free pot" and a "drawdown pot", but leave both invested and take income as required from either pot. So, in this case, would it be possible to crystalize the SIPP into £125k with a tax-free income and £375k with a taxable income ...
    I think you have the wrong end of some stick or other here. When Youinvest say you can do this, what I believe they mean is that they will split your holdings 75/25, move 75% into a drawdown pot and the remaining 25% as your PCLS into an unwrapped trading account. After crystallising a pension, the PCLS element has no special tax status. It is part of your estate for IHT, and you will have to pay tax annually on any dividends or interest it earns, and any capital gains on asset sales.
    ... and then draw £25k pa of taxable income from the latter each year and not be liable to an excess LTA tax at age 75?
    You would need to taxably draw all the nominal gains in the drawdown part before age 75 to avoid an LTA penalty. £25k is 6.7% of £375k, so provided average growth does not exceed this you should escape. I generally use numbers of 3% for inflation and 4% for growth, so you're close to my guess (though of course, a guess is precisely what that is).
    Indeed, if necessary, you could also take out up to £125k from the first pot in an emergence tax-free at any time, but if it was not needed, then the full £500k could be passed on, IHT free to children on death.
    Your numbers seem to be missing growth. Assuming no growth though, not £125k of it, since this (as noted above) is part of your estate for IHT once taken as a PCLS. Only the drawdown part is protected from IHT.
  • caveman8006caveman8006 Forumite
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    Thanks - I agree that AJ Bell probably did not understand my question, and were probably describing parallel "unwrapped" and "drawdown" accounts, rather than the hoped-for "100% iht-protected" solution.
    However, that still leaves open the best strategy for maximising iht protection without triggering LTA tax.


    By taking the full £125k income tax free at the outset , only £375k is ever protected from iht. Assuming a conservative 5%pa investment return, that £375k drawdown pot will generate £18,750pa of investment returns that will need to be taken out as taxable income until 75 after which further returns can be left to grow without any LTA charge.


    Alternatively, the potential LTA charge could be avoided by annual UFPLS withdrawals of £25,000 of which £18,750 would again be taxable and £6,250 would not. After 10 year of this the LTA would be used up, so for the last 5 years until 75, the full £25k of returns would have to be taken out as taxable income. After 75, the iht-protected pot could be allowed to grow. This seems to be a more efficient strategy, albeit with the slight complication that some top-rate income tax my have to be paid in the last 5 years if a full state pension is being received.


    Thoughts?
  • edited 18 June 2019 at 8:42PM
    EdSwippetEdSwippet Forumite
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    edited 18 June 2019 at 8:42PM
    Alternatively, the potential LTA charge could be avoided by annual UFPLS withdrawals of £25,000 of which £18,750 would again be taxable and £6,250 would not. After 10 year of this the LTA would be used up, so for the last 5 years until 75, the full £25k of returns would have to be taken out as taxable income.
    Once the LTA is used up, you can no longer use UFPLS and all future withdrawals from uncrystallised elements are liable to the LTA penalty. On a £25k crystallisation, you would lose £6,250 to LTA penalty, and then face income tax at your marginal rate on the remaining £18,750.

    Put differently, below the LTA you get 25% tax free, but above it the government takes all of that 25% for itself instead, then income tax on the remainder in both cases.
  • caveman8006caveman8006 Forumite
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    Silly mistake in my previous posting, I would only have crystalized 15 x £25k = £375k of my unused £500k LTA by 75 so would not have used up all my LTA at 70. Makes it even clearer to be a more efficient strategy than full crystallization at outset
  • edited 19 June 2019 at 12:05AM
    EdSwippetEdSwippet Forumite
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    edited 19 June 2019 at 12:05AM
    Silly mistake in my previous posting, I would only have crystalized 15 x £25k = £375k of my unused £500k LTA by 75 so would not have used up all my LTA at 70. Makes it even clearer to be a more efficient strategy than full crystallization at outset
    Aren't you still discounting the effect of above-inflation growth in your pension? Assuming your initial conditions -- that is, already at the LTA -- if you gradually UFPLS, by the time you hit age 75, investment growth in the uncrystallised bits should have caused you to handily exceed the LTA (unless you have invested in assets that have consistently returned less than inflation!). So now you have an LTA penalty to pay at the age 75 test.

    Once you reach exactly the LTA, the only way to truly avoid an LTA penalty is to crystallise everything, and then draw down all the nominal growth to age 75. Otherwise, investment growth will take you over it one way or another, and you then face LTA penalties either when you crystallise above it, or run out of time at age 75. To my mind, UFPLS is of no use to anybody whose pension pot is at or above the LTA. It just compounds the problem into the future.

    I should add that I do not know the full ins-and-outs of how this all interacts with IHT. I plan to draw my pensions, so my own planning does not consider using pensions as an IHT shelter. I also don't know well how DB pensions work into all of this. However, as someone now at the LTA with purely DC pensions, I am crystallising everything now. Tax rates outside a pension are almost all lower than those on withdrawals from a pension that is above the LTA.
  • edited 19 June 2019 at 1:48AM
    jamesdjamesd Forumite
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    edited 19 June 2019 at 1:48AM
    I have been told by AJ Bell/You Invest that they allow you to "crystalize" the SIPP into a "tax-free pot" and a "drawdown pot", but leave both invested and take income as required from either pot.
    Did they say that:

    1. both pots would still be in a pension?
    2. not specify which would be in a pension?
    3. only say that the taxable portion will be in a pension and not where the other portion would be?

    You are not permitted to have a crystallised setup where the lifetime allowance has been calculated before age 75 and still have both 25% tax free and 75% taxable still in a pension. And they can't offer you that, nor can anyone else. So I think that they did 2 or 3.

    What is normally done if lifetime allowance use is needed but no income is desired is both:

    a. take the 25% tax free lump sum and place it into an ordinary investment account that's neither pension nor ISA. This is part of the estate unless the money is invested in things like many AIM shares that become exempt after a couple of years.
    b. place the 75% in a flexi-access drawdown account that is outside the estate and from which no money needs to be taken. At age 75 the value has the initial value subtracted from it. If the answer is positive the growth in value uses more lifetime allowance. So if lifetime allowance is a concern at least withdrawing growth tends to be appropriate.

    If it's desired to keep as much inside the pension as possible you can:

    C. used phased drawdown. This is taking 25% of part of it tax free and putting the 75% of that portion into flexi-access drawdown from which any desired amount can be taken.
    D. wait until 75 and pay any due lifetime allowance charge via BCE 5B. Note HMRCs observation that "For avoidance of doubt, for pension and lump sum purposes the £70,000 remains uncrystallised". Since they remain uncrystallised you can still take a PCLS (the tax free lump sum) if you want to take out some of the money. As HMRC illustrates here at age 76. Also observe how it's a bit fiddly to calculate the LTA used when crystallising older than 75. But entirely doable.
    E. do some combination of a+b, C and D.

    It may well be possible to keep most of the money uncrystallised in the pension until and after age 75 and do enough of a+b and C to pay no LTA charge. But...

    For death before age 75 the pot isn't taxable to the recipients. From age 75 it's added to their taxable income as taken (no 25%:75% split). Even babies have an income tax personal allowance and the taxable money can be withdrawn and used for their needs up to their personal allowance with no tax to pay. So after 75 skipping generations to help children via covering the costs of their children can be tax efficient.

    Even with the workarounds, taking the 25% tax free and giving it away as a potentially exempt transfer well before death may be best.

    I'm assuming that you're far from age 75 and AJ Bell weren't describing case D.
  • edited 16 August 2019 at 5:15PM
    caveman8006caveman8006 Forumite
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    edited 16 August 2019 at 5:15PM
    Say, for simplicity, that the LTA allowance is £1m with no indexation and you have exactly "landed" at that at age 60 via a combination of a £25k pa DB and a £500k SIPP. Also, you have a large ISA pot which, together with your DB pension and the investment returns from your SIPP (let's assume £25k pa), will be sufficient to cover your income needs for the rest of your lifetime. So, to maximise the IHT protection of your SIPP wrapper, you only wish to draw the investment returns from your SIPP as taxable income to avoid an eventual LTA charge at 75. What is the best way to manage the SIPP?


    I have been told by AJ Bell/You Invest that they allow you to "crystalize" the SIPP into a "tax-free pot" and a "drawdown pot", but leave both invested and take income as required from either pot. So, in this case, would it be possible to crystalize the SIPP into £125k with a tax-free income and £375k with a taxable income and then draw £25k pa of taxable income from the latter each year and not be liable to an excess LTA tax at age 75? Indeed, if necessary, you could also take out up to £125k from the first pot in an emergence tax-free at any time, but if it was not needed, then the full £500k could be passed on, IHT free to children on death.


    Just to try and clarify this point one last time: my description of differentiating between the 25% "tax-free" and 75% "drawdown" components of the hypothetical £500k crystalized pot was clearly mistaken as the potential to take up to 25% of crystalized funds tax-free is a one-off opportunity that can't be returned to later. However, I still think that it is possible to choose to crystalize the full pot without taking any tax-free income. In this case, surely, the full £500k would be transferred into the drawdown account and remain IHT-free provided that the annual investment returns (assumed to be £25k in this scenario) are taken out as (basic rate) taxed income each year. The eventual saving of 40% IHT on the extra £125k retained in the SIPP would far outweigh the alternative of gradually recycling the same amount (over several years) into a tax-free ISA which would then be subject to 40% IHT as part of the estate on death?
  • edited 16 August 2019 at 6:14PM
    jamesdjamesd Forumite
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    edited 16 August 2019 at 6:14PM
    Just to try and clarify this point one last time: my description of differentiating between the 25% "tax-free" and 75% "drawdown" components of the hypothetical £500k crystalized pot was clearly mistaken as the potential to take up to 25% of crystalized funds tax-free is a one-off opportunity that can't be returned to later.
    There is never an opportunity to take tax free money from a crystallised pot, that chance is lost once you crystallise. But substitute uncrystallised and it's all right.

    However, I still think that it is possible to choose to crystalize the full pot without taking any tax-free income.
    It is. Anything from 0% to 25% is permitted when crystallising an uncrystallised pot.
    In this case, surely, the full £500k would be transferred into the drawdown account and remain IHT-free provided that the annual investment returns (assumed to be £25k in this scenario) are taken out as (basic rate) taxed income each year.
    Yes 100% could then go into drawdown. It'd be out of the estate whether the 25k is taken or not, taking that is just to avoid a lifetime allowance charge at 75 or because the income is wanted.
    The eventual saving of 40% IHT on the extra £125k retained in the SIPP would far outweigh the alternative of gradually recycling the same amount (over several years) into a tax-free ISA which would then be subject to 40% IHT as part of the estate on death?
    Depends on the circumstances and preferences. Some might invest in VCTs to mitigate the income tax while alive and make potentially exempt transfer gifts while alive. Either way can work.

    The VCT then gift approach has lower likely total tax cost if death is at 75 or older because then the pension money is taxable as income for the beneficiary when withdrawn, while a PET given 7 years before death is tax free for the recipient and estate. But babies have their own income tax personal allowance and withdrawing 12.5k for 18 years and using it for the benefit of the child, which includes food, clothing and such, can be a viable alternative tax reduction approach.
  • BrynsamBrynsam Forumite
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    Thoughts?

    Yes - invest in some proper independent financial advice. Could be an excellent investment!
  • AlbermarleAlbermarle Forumite
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    Whichever route you take , you can 'adjust' the possible growth rates in the SIPP ( or ISA) by changing the risk/reward balance in the investment portfolio. Not a lot of point going for a high risk/high potential growth investment strategy in a pension if you are in the LTA limit area. Maybe not even the usual medium risk 50:50 ( +/- 10%) strategy is ideal and something safer still can make sense ?
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