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RETIREMENT REVOLUTION January 2015 BUY TO LET VERSUS DRAWDOWN - or how cashing in a pension pot to invest in a Buy to Let property could provide a retirement income. THE SITUATION Paul Brown is 61 & married to Patricia (Pat), who is 58, and they have 2 adult children - Colin & Clare. Paul enjoys his consultancy work and, while he’s reducing his hours, has no plans to fully retire before he’s 70. He has a personal pension fund valued at £250,000 & used a £50,000 inheritance when his father passed away as a deposit for a new build property that he purchased early in 2013 for £165,000. He’s renting this property at £695 a month (5.05% gross yield), but would charge more to new tenants. He expects to receive net rental income of £2,900 a year (1.76% net yield) , based on his experience so far of expenses and void periods. Paul is suspicious of pensions and influenced by the no-one needs to buy an annuity again headlines. Having researched the market, Paul concluded that if he took 25% tax free cash of £62,500, the £187,500 balance of his pension fund would secure, what he considers a disappointing initial RPI indexed income of £5,004 a year plus a 100% spouses pension for Pat. Having taken advice, the general consensus is that an annuity isn’t right for someone in Paul’s position. He doesn’t need to secure a lifetime income, both he and Pat are relatively young, in good health and don’t smoke - and their exclusive postcode is another disadvantage when it comes to annuity purchase. THE EXPECTATION Paul’s instinct is still to use the 2015 pension rules to unlock his pension cash to purchase a second B2L property to provide additional income both now and when he ceases paid work. He believes he’d be able to buy a similar property for £180,000 plus legal expenses & stamp duty, & rent it out for £795 a month. Based on his experience so far, he expects to get a net rental income of £8,590 a year but accepts it could be less than this. He sees significant advantages compared with an annuity. He’d not only get a higher increasing income, but also the possibility of capital growth. If he predeceased Pat, she would inherit the property free of Inheritance Tax, along with the full income stream. His children could also inherit the property - albeit possibly subject to Inheritance Tax. Paul explains his thinking on how he’ll finance the purchase. He plans to limit his consultancy earnings for 2015/2016 to £30,000, and expects to get £2,900 net rental income from the existing B2L and about £4,300 net over six months from the new property. His understanding is that provided he ensures his other income is within the basic rate band, he’ll be entitled to 25% tax free cash of £62,500 and will pay 20% tax on the £187,500 taxable portion of his lump sum leaving him with £212,500. Here is Paul’s first mistake! THE REALITY The actual tax rate will be more like 42% - that is over double Paul’s expectation. The actual tax on the £187,500 would be £78,735 - £41,235 more than Paul’s calculation of £37,500. The reason is simple - the amount of a taxable pension pot that is taken during a tax year gets ADDED to other income for that year. Ouch! Here we look at Paul’s tax position assuming 2 scenarios - taking all of the pension fund & buying a second B2L - click to see not drawing on his pension fund - click to see THE RESULT Having gone through that reality check, Paul’s open to discussing other options and confirms that he’d only planned on restricting his consultancy income to £30,000 based on his misunderstanding. He has no immediate need of additional income. It is suggested that initially, he could leave his substantial pension funds invested across a broad range of investment classes (including property funds) rather than using all his funds on a single B2L property. Capital gain leads to CGT. One of the key attractions of B2L to Paul is the growth potential from property. He hadn’t fully considered that not only would the net rental income be taxable, but he’d have to sell a property to access any gain - when he’d be liable to Capital Gains Tax (CGT). In contrast, pension funds grow virtually free of taxes on the income and capital gains from the underlying investments. Keep control! Paul is also interested in controlling the amount of his income and subsequent income tax. It is pointed out that when he wants to use his funds to provide an income, he could use phased flexi-access drawdown - basically, using his pension fund as a savings account that he can dip into when he needs some cash. As an example, Paul could designate £10,000 of his funds to provide income. He could take 25%, or £2,500, as tax free cash & then draw down on the remaining £7,500 flexibly - taking as much or as little of this income as he needs, with any income being taxable at his marginal tax rate. He could repeat the exercise over & over, which would give him significantly more control over his income mix and marginal tax rate than rental income from a second B2L property. Also, the undrawn funds would continue to benefit from a tax advantaged investment environment even after being designated to provide pension income. TAX TIP! - click here Save on IHT B2L also drew Paul’s attention because of his concerns about providing pension benefits for Pat & an inheritance for his children. He is reassured that if he dies before 75, all his remaining un-crystallised and drawdown pension benefits can be paid out as a lump sum or as drawdown income to Pat and/or his children - free from tax and outside his Inheritance Tax estate. If he dies after 75, any remaining funds can be paid via flexi-access drawdown to Pat and/or his children. They’ll have to pay income tax at their own marginal rate on the funds they receive. THE CONCLUSION Paul now realises he hadn’t considered the disadvantages of taking all his pension benefits as a lump sum and relying on B2L properties to provide him with a retirement income. He recognises the advantages in taking his benefits as a lump sum. He recognises that it should be possible to combine tax free cash, flexi-access drawdown and partial pension encashment to provide him with a more tax efficient retirement income when he needs it. He also realises this could offer inheritance tax planning advantages - particularly if it comes to making provision for his children.
NOTES: We do our best to keep things as straight forward & simple as we can, but please bear in mind that pensions can be a technical & complicated subject. We would suggest therefore that there may be items in this article that may need more explanation. If that is the case, please do not hesitate to contact us Any reference to people , both living or dead, are purely coincidental Click here to download a pdf version of this case study that you can print out.