Pension freedoms introduced in 2015 have fuelled a rush to buy-to-let investment using previously inaccessible funds. While this may appear laudable to many, it often has catastrophic tax consequences with tens of billions being lost and further billions in latent Inheritance Tax (IHT) waiting to manifest. In this piece we will identify the issues and address them.
What happened in 2015?
In 2015, legislation was passed in the Pension Schemes act allowing those aged 55 or over to access their pension “flexibly”. This means that upon attaining age 55 members of defined contribution pension schemes can draw a 25% tax-free lump sum from their fund and the balance can be withdrawn as income – as frequently or infrequently as desired – or even in one lump sum.
It seems that there are an awful lot of people who trust their bank more than their pension provider with nearly half (48%) cashing in their pension to put the money on deposit.
This is insanity.
The problem with taking an entire pension fund as a lump sum is that the majority of it is taxable and this will likely push the recipient in to the higher (or even additional) rate tax bracket. So that’s the first spanking – income tax.
Tax payable on lump sum pension fund withdrawal 2020/21
|Pension fund value £200,000|
|Total tax paid||£66,000||£75,000||£97,500|
|Total lump sum after tax||£137,500||£132,500||£130,000|
|Tax paid @ 20%||£7,500||£7,500||£7,500|
|Tax paid @ 40%||£45,000||£45,000||£45,000|
|Tax paid @ 45%||£13,500||£22,500||£45,000|
Next, the funds have now moved into the recipient’s estate for IHT purposes. Should they be unfortunate enough to be run over by the proverbial No. 9 bus, the estate now stands to lose 40% of the remaining fund in IHT.
Finally, as is common in the previously stated statistic, rates of return on deposit are negligible and generally less than inflation so the money is being stolen every day by this silent, invisible thief that no vault can protect it from.
The rise of the retiree landlord
So, what are the other half of those that encash doing with their money if not stashing it in the bank? Well, a significant chunk (29%) are withdrawing to purchase buy-to-let property. This is admirable – people taking control of their personal finances always is – but still folly. All of the tax consequences previously stated apply and the IHT problem then becomes further compounded by the addition of properties to the estate.
How would we do it?
Keeping in mind that the reason nearly everybody takes out a pension in the first place is to provide an income in later life and also that the reason people are encashing their pensions and paying huge amounts of tax is to buy rental property, it seems nonsensical not to combine the two.
It is a commonly held misconception that pension schemes cannot invest in residential property. There are quite clear exemptions, in both primary legislation and HMRC guidance, to the circumstances in which an investment regulated pension scheme can hold residential property. One of these exemptions involves investments made through a Genuinely Diverse Commercial Vehicle (GDCV).
The reasons for investing via a GDCV are clear:
- No need to encash pension fund and pay tax
- Ability to buy and hold residential property
- Rental income received free of tax by the pension
- Disposals of property are free of Capital Gains Tax (CGT)
- All property is out of the estate for IHT purposes
- If over 55, rental income received by the scheme can be drawn as and when desired
|Pension fund value £200,000|
|Leverage @ 75% LTV||£412,500||£600,000|
|Gross Yield @ 8%||£44,000||£64,000|
|Increased yield using GDCV||45%|
Clearly by not encashing to invest and retaining the tax benefits of the pension scheme by using a GDCV to hold the property, the improvement on the overall financial position is staggering.
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