1st April 2015
Next week will finally see the arrival of the UK’s retirement industry overhaul, whereby savers will be able to do as they please with their nest-egg.
While the new freedoms have been universally welcomed, concerns are rising that some intrepid retirees may act in haste and endanger their life-savings, especially those who maybe tempted to dive into the property market.
But for all the chatter over people blowing the funds on luxury holidays or buy-to-let properties, the reality is that most pension schemes will not be able facilitate the new freedoms on Day 1 and the vast majority of savers will take time to carefully weigh up their options before rushing into a course of action.
David Smith, financial planning director at Tilney Bestinvest said: “People who have saved diligently across their lives for the moment of retirement do not transform into reckless hedonists at the point of retirement.”
However Smith highlights that one possible development of the radical changes to pensions could be that a number of individuals look to give up their purpose-built retirement savings plan to replace it with a buy-to-let property.
He added: “Looking at how the figures stack up, this could prove to be a costly mistake.”
Below Smith explains an example of what could happen to budding landlords and how their experience could compare to a retiree going for income drawdown…
Dick draws his pension fund out as a lump sum and buys a property to let:
Dick is 65 and has built up a pension fund of £150,000 during his lifetime. At retirement he will only receive 25% of his pension fund tax free (£37,500) – the remaining 75% (£112,500) will be taxed at his highest marginal rate of income tax. So, even if Dick receives nothing other than a state pension of £10,600 per annum but decides to withdraw his £150,000 pension as a lump sum, he would only receive £107,117 in his hand, with effective tax of up to 60% payable on part of the monies withdrawn. This effectively represents just 71% of his pension value.
Dick now only has £107,117 to purchase a property including the costs associated with property purchase; solicitor’s fees, valuations, searches and stamp duty – not to mention any refurbishment costs. Let’s say in this example, the property cost £105,000, no refurbishments were required and the associated fees are covered by the remaining £2,117. Once the transfer of ownership completes the retiree now has a property worth £105,000 – so he’s already lost 30% of his pension.
Never mind – the good news is that this Dick has a tenant lined-up who wants to stay in the property indefinitely and is willing to pay a healthy £525 per month rent (representing a 6% gross yield, but only 4.2% based upon the actual pension value of £150,000). Effectively Dick’s ‘pension’ is therefore now providing a gross income of £6,300 per annum but unfortunately tax of 20% will be payable on this amount, resulting in his net income being £5,040 and this does not take into account the costs associated with managing a buy to let property; maintenance, repairs, time spent and potential periods without tenants, all of which would lower this yield further. And remember, the more people who look to invest their pension monies in this manner, the more under pressure rental yields will become.
To add insult to injury, upon sale of the property, any gain made on the value could potentially be subject to Capital Gains tax of up to 28%. But the property isn’t sold, as Dick unexpectedly dies just before selling it: He’s 70 years old, widowed and has no Inheritance Tax nil rate band available so, if the value of the house had grown to £120,000 at the date of death, his beneficiaries would pay tax of up to £48,000. Furthermore, HMRC would not allow the house to pass to Dick’s beneficiaries until after the inheritance tax has been paid. So within 5 years Dick has turned a £150,000 pension into an asset worth just £72,000 for his children.
But in contrast…
Tom, also 65, decides to keep his £150,000 pension fund, draws a net income from it of £5,040 each year and achieves a net growth rate of 4% per annum. Under such circumstances Tom would still have a pension fund of £149,000 at the end of five years and would have received a total net income of £25,200. It is also important to note that part of Tom’s income will be funded from his tax-free cash entitlement, which reduces the income tax that his monthly income would be subject to.
However, perhaps the biggest ‘win’, is the fact that Tom’s pension can potentially be passed to successive future generations inheritance tax free. Even in a worst case scenario the tax would only be payable at recipient’s marginal rate of income tax.
The story in numbers…
|Use pension to buy BTL||Maintain Pension|
|Starting value of pension||£150,000||£150,000|
|Tax on lump sum withdrawal||(£42,883)||N/A|
|Cost to fund BTL purchase||(£2,117)|
|Value of ‘pension’ after BTL purchase||£105,000||£150,000|
|Total net income after five years||£25,200||£25,200|
|Value of ‘pension’ after five years / date of death||£120,000||£149,000|
|IHT Payable on death||(£48,000)||£0|
|Net Proceeds to beneficiaries||£72,000||£149,000|
|Growth / loss to estate over five years||£72,000 + £25,200 – £150,000= £46,800 loss (31.2%)||£149,000 + £25,200 – £150,000= £24,200 growth (16.1%)|