With significant reductions in the annual and lifetime allowances for pensions, further cuts due next year and political pressure for more after that, an alternative strategy is needed for clients who want to make substantial provision for retirement.
Offshore bonds are a natural choice as a complement to a pension. Although there is no front-end tax relief, funds have the same tax regime inside the wrapper – no deductions other than withholding tax. Also, the open architecture of an offshore bond means that the investment choices are similar to a Sipp, so the client can follow a consistent portfolio strategy.
The same considerations apply for someone who is unable to get tax relief on contributions to a UK pension plan – for example, if they spend a period working abroad and are non-resident for UK tax purposes.
This use of offshore bonds is generally well known. But what about the longer term? If someone has built up investments in both a UK pension plan and an offshore bond, how should they run them to best effect and which should they draw on first when they come to retire?
A case in point…
Let us look at a case study. Marie worked for several years in the UK and built up a fairly substantial pension fund. She then moved to work in Dubai for a number of years, but knew she would return to the UK before she retires, as her family lives there. Before leaving the UK, she took out an offshore bond and continued to add money to it while she was away.
Marie came back to the UK at age 55. Her pension fund is now worth £800,000 and she has £400,000 in her offshore bond. She could decide simply to take her pension at this point, but she wants to work for a few more years.
However, she does want some cash to help her buy a house. By moving her pension fund into drawdown, she is able to take £200,000 of tax-free cash. She can also take an income from the balance of her pension fund and recycle this back into a pension plan, as long as she has sufficient earned income to be able to cover the contribution.
This operation is tax-neutral – the tax relief on the new pension contribution cancels out the tax due on the income drawn down. The benefit is that, when she retires, she will be able to take a further tax-free cash sum based on these additional contributions. They are also uncrystallised funds, which means they will not be subject to the recovery charge if Marie dies before age 75.
Marie takes the maximum 120% of the GAD allowance for her age each year and recycles it all back into her pension. With annual growth on the fund of 5% after charges, the outcome after five years would be as shown in Table 1 (see below).
If Marie were to die at this time, the recovery charge would be 55% of the crystallised funds – £304,221 – instead of 55% of the whole fund, which would be £421,173.
Early retirement
Marie now decides to retire at age 60. At this point, she leaves her pension – with no earned income, she cannot make further contributions – and brings her bond into play.
With no other income, she can cash in segments of her bond to provide her with an income and use her personal allowance to offset some of the tax due. As the tax is in any case charged only on the profit, this is very tax efficient (see Table 2 below).
During the five years, Marie has withdrawn a total of £211,148, but paid only £8,758 in tax – equivalent to 4.15%.
There are further benefits to using the bond at this stage rather than drawing on her pension. Withdrawals are fully flexible – not restricted by her age and GAD rates, as would be the case with a pension in capped drawdown. Also, with regard to inheritance tax planning, the bond is potentially subject to IHT whereas the pension is not, so it is better to use the bond assets first.
Bypass trust
However, Marie still has an IHT concern around her pension. Her nearest relative is her brother and she is concerned that, if he were to inherit her pension fund, it could create an IHT problem within his estate.
One solution is a bypass trust. Though commonly called a ‘spousal bypass’, this can be done for any beneficiary. Marie sets up a trust outside the pension and then makes an expression of wish that death benefits are paid to the trust.
The trust is discretionary, so Marie can include her brother as a beneficiary, meaning he can have access to the trust fund, but it will not be within his estate. She can also make his children beneficiaries. In addition, she retains control over the terms and beneficiaries while she is alive. So, for instance, if her nieces and nephews have children, she could add them as beneficiaries.
As the trust is discretionary, it may be subject to periodic and exit charges. However, rather than paying money out to beneficiaries, trustees could make loans to them. This might be useful if Marie’s brother needed some money; the loan would be repayable to the trust on his death, thereby reducing his estate.
When to switch
Although Marie does not have an IHT issue with her drawdown fund, it will be subject to a 55% recovery charge on the crystallised funds if she dies before age 75 and on the whole amount if she dies after that age, if it is passed on as a lump sum. So she does need to think about either spending the money or transferring it into a more tax-efficient environment.
By this time – Marie is now 65 – her pension fund has grown to £977,337 (assuming a continuing annual growth rate of 5% after charges), of which £271,387 is unvested. She can, therefore, take tax-free cash of £67,847. She withdraws a lump sum from her bond (on which she will pay income tax on the amount in excess of the accumulated 5% tax-deferred allowance) and uses this plus the tax-free cash to buy an annuity of £20,000 a year.
This allows Marie to be able to move into flexible drawdown. She now takes an income of £80,000 a year from her pension fund – together with her annuity this is the maximum she can take without losing any personal allowance.
She will pay 40% income tax on some of the money, but this is preferable to the 55% recovery charge.
From her £100,000 annual income, she spends £70,000 on tax and living expenses and puts £30,000 into an offshore bond inside a Gift Trust. As she is doing this every year, it counts as normal expenditure out of income, so is exempt from IHT.
By the time Marie reaches 75, she will have reduced her pension fund to £424,920 (again assuming a 5% net annual growth rate), while the trust fund will now be worth £396,204. Although there would still be a sizeable recovery charge on the pension fund – £233,706 – she has sheltered a larger sum in the trust.
Meanwhile, Marie could put the remainder of her original bond into a Loan Trust. This would mean she retained access to the capital, but any growth would be sheltered from IHT.
By the time Marie reaches the age of 81, she will have taken all the money out of her pension fund and transferred it to the bond in trust, now worth almost £750,000. Her income will now drop to the £20,000 from her annuity, but she still has the capital sum in her Loan Trust intact, which is about £265,000.
The growth on this – now worth some £300,000 – is entirely sheltered from IHT and she can draw on the capital as she chooses, to supplement her annuity (subject to an income tax liability).
In all, she has built up more than £1m for her beneficiaries free of IHT and has meanwhile enjoyed a good standard of living for herself, without paying any more tax than is necessary.
