The new limit of a £40,000 annual allowance for higher-rate tax relief on pensions may be under pressure

Abolishing higher-rate relief has been on the LibDem manifesto for some time. The TUC has argued it costs the Treasury more than public sector final-salary pensions.

The Centre for Policy Studies’ report suggests that as well as limiting tax relief for pension contributions with the annual cap, that tax relief could either be changed to a flat rate, rather than being given at the marginal rate or that, over the longer term, pension savings should be aligned with the Isa regime, with no tax relief up front but growth and income from retirement savings could become exempt.

If George Osborne likes the sound of the report, it will mean massive changes to the way that advice on pensions is given

A flat rate of 20 per cent tax relief across the board would save the Treasury about £7bn a year, every year, a massive contribution to reduction of the deficit, which is the Government’s number one priority.

What would the consequences be?

The majority of those in company schemes would continue to save because of the employer contribution and the very wealthy, who get most of the higher-rate tax relief, would save elsewhere.

They will never be poor in retirement anyway, so, from a Government point of view, what is to be lost?

Cutting the Conservatives’ electoral base’s tax relief in half would not go down well in the shires, or in the press.

Suggestions are that the chances of higher-rate relief surviving another two years at less than 50 per cent.

If it is not higher-rate tax relief that goes, then the Treasury will surely look again at tax-free cash. Abolition would save around £2.5bn a year – halving it to 12.5 per cent would generate half that figure. These are significant sums when compared with the cuts that government departments are being asked to make over the next few months.

Some have pointed out that such an overhaul, just four years after A-Day, would be nearly impossible because of the complexity involved. That has never stopped them in the past.

If we do head into a double dip, the chances of Osborne having to call on the extraordinary measure of getting rid of higher-rate relief will rise. Even if he does not get rid, there is nothing to stop him from chipping away at the £40,000 limit.

Action to take

If you are a higher rate tax payer perhaps you should review the amounts you are putting into your pension now, However with the stock markets in a very volatile state good investment advice is essential.

Chief Exec of Pimco and a FT commentator, Mohammed El-Erian believes that investors have lived the past 20 years under a belief where investment rules of thumb worked. 

But no more!  The past is no longer a guide to the future (if it ever was). 

Instead, he says, the dispersion (or variation) in policy-maker’s expectations is unusually wide for basic economic variables such as growth and inflation and the likelihood of policy mistakes (such as interest rate or tax & spending policy) is greater than it has been for the past 25 years. 

As a result, few investors are likely to see ‘average returns’ on their investments. Instead, some will perform much better than the average and some will perform much worse. 

Which begs the question; can this be the fault of the investment manager? And if not, on what basis does the wealth manager recommend investments or pension funds to his or her clients? 

Tough investment questions don’t go away

Okay, let’s firstly acknowledge that the decision or recommend or select an investment manager, pension fund manager, unit trust or other collective investment has always been a tough decision. Nothing new here. 

However, for many years onshore and offshore wealth managers have been able to back up their investment decisions (and in many cases were legally required to do so) with evidence of past performance. 

If past performance is becoming less and less linked to future performance what does the wealth manager do? 

What now counts as a good reason to select an investment manager or product’? 

El-Erian goes onto explain some more 

1. Fluctuations in price will increase / widen and this will create short term investment opportunities (and risks).
2. There will be a gradual movement away from assets where the predictability is reduced, such as equities, along with a greater desire to hold liquid assets and this shift in demand will drive prices accordingly.
3. Historical benchmarks will be challenged and broken, so investment strategy will need to begin with first principles.
4. Some investments will simply melt-down, we’d better get used to this
5. Asset diversification is no longer enough to reduce risk.

El-Erian is telling us that we simply need to invest from first principles (or current strategy), not on the basis of past performance and that we need to find a way to more actively manage our investments. 

Or to put it another way, if your share goes up more than you expected, sell! It is probably a happy accident that will be reversed. 

Equally, if a share falls more than expected – then consider buying (slowly), as it might be an unhappy accident that will be reversed. 

Conclusion

The critical conclusion here is that there is less and less benefit from the traditional buying and hold strategy. When a stock, asset or investment index reaches an unusual or unexpected high, sell it and take profits.

 Therefore, passive investment vehicles, such as index tracker funds, are unlikely to deliver decent returns (or even average returns) for the level of risk taken. 

Hence, active management, with a clear investment strategy is the best route forward and proactive wealth managers are in an ideal position to help their clients. 

Diversification (and hence risk reduction) will only be achieved not by investing in different assets classes but by investing in different investment strategies.

The wealthy have no time to lose in planning their IHT mitigation

The recent announcement that inheritance tax (IHT) mitigation via transfers into trust is likely, in future, to be included in the Disclosure of Tax Avoidance Schemes (Dotas) regime is not good news.

The Treasury and HM Revenue & Customs (HMRC) proposal is what was expected following the Finance Act 2010’s blocking of two specific trust schemes which dramatically (and arguably artificially) reduced the value of assets gifted into trust.

The new government has firmly declared its IHT plans by freezing the inheritance tax threshold, the nil rate band (NRB), for five years, it is backing this approach by supporting legislation to plug as many “leaks” as possible.

The consultation document introducing the Dotas requirement does not seem unreasonable in the circumstances, as it does not impact on most conventional IHT mitigation work using the various trust schemes that are widely available.

So what exactly is being suggested as far as disclosure is concerned?

The new rules will not require any existing schemes used extensively by Bluebond  and well known to HMRC to register, such as flexible and discounted gift schemes, because they are being ‘grandfathered’ into acceptability. The only new trust schemes that have to be registered will be those that involve:

• chargeable transfers beyond the donor’s current allowances, including any unused NRB. In other words, where property becomes ‘relevant property’;
• an ‘advantage’ in relation to the IHT entry charge: an advantage being defined as the avoidance, reduction or deferral of a charge.

This avoids any requirement to disclose straightforward situations where an individual simply transfers property into trust and relief, or exemption is available in the same way it would have been had the property been gifted directly to another individual. This is generally the case with most of our of trust-based mitigation arrangements.

The government’s proposal is only at the consultation phase so it is too early to be unequivocal about the requirements for plans launched in the future.

However, the grandfathering facility will ensure all existing plans of which HMRC is aware and future plans that adopt the same principles as existing plans will be safe. This is the nearest we have ever come to having a blanket approval from HMRC of all existing plans.

What does this mean for tax planners and their clients?

The proposals are bad news for taxpayers who have been relying on either the indexation of the NRB or, more recently, the Tory commitment to a transferrable £1 million NRB, to lift them out of potential liability. The coalition government has a much less generous approach to inherited wealth than that promised by the Tories.

Freezing the NRB for five years when the knock-on impact of quantitative easing is likely to be rampant inflation down the line is serious. Inflation is already rearing its ugly head, no matter what interest rates are doing.

Looking further ahead, there has been plenty of speculation that the coalition might continue until another term of government, especially if next year’s referendum delivers backing for the alternative vote electoral model. This will mean the cautious approach to raising IHT allowances will continue.

This means taxpayers who are currently close to a potential IHT liability will be severely disadvantaged by the NRB freeze, assuming inflation of 4% over the next two years followed by 8% for three years.

A potential liability of nil at the beginning would become a liability of around 40% of £117,814 after five years that is more than £47,000, simply resulting from inflation.

Hope for the best but prepare for the worst

IHT planner Charles de Lastic constantly reminds his clients to ‘hope for the best but plan for the worst’. This has served him well over many years of capital tax planning.

The message here is that everyone who, since 2008 when they were given false hope by the last labour goverment, has put off their IHT mitigation planning has no time to lose.

Remember: hope for the best but plan for the worst; start your IHT mitigation planning today.

The cost of Transport fall, but prices for food rise as inflation drops to 3.1%, but is still well over above the 2% target.

Inflation dropped down in July, but remains far above the government target imposed on Bank of England.

The annualised 3.1% rise in consumer inflation for July was down on June’s 3.2% increase, but still above the 2% target. This means that the BOE governer will have to write yet another letter to the government explaining why price rises are above target.

Bank of England Governor Mervyn King blamed anumber of one-time factors, including the rise in sales tax in January, past rises in oil prices and the continued effects of higher import prices following the devaluation in the British pound since mid-2007.

King reiterated the bank’s projections that inflation will remain above the target until the end of 2011 — a year longer than it was predicting just a few months ago — but would then fall back as the effects of higher sales tax, energy price rises and import price increases drop away.

King said last week that inflation was likely to fall back below target in 2012, but in Tuesday’s letter to Treasury chief George Osborne he acknowledged that the recent strength in inflation had surprised the bank’s rate-setting committee and “how fast and how far inflation will fall are both difficult to judge.”

Transport costs were the main factor in the slight drop in inflation with the price of second-hand cars falling between June and July. Petrol prices also fell.

Conversely, food and non-alcoholic beverage prices added upward pressure on the overall figure. With the current prices rises in wheat this is likely to continue.

The same factors also saw the RPI measure of inflation – used for indexation of pensions and state benefits – drop slightly from an annualised 5% to 4.8%

The Bank of England said that inflation will stay above the 2% target for longer than it forecast back in May. The Bank’s new forecasts showed inflation above target until the end of 2011 but falling after that as ‘temporary’ factors such as the increase in VAT next year fade.

Inflation in the UK is higher than in the EU as a whole, where consumer inflation was measured at 1.9%.

Consumer Confidence

This week saw consumer confidence drop to its lowest level for 15 months, it also saw the pound falling against the US Dollar as investors became nervous about the state of the world economy.Consumers are perhaps worried about the level of disposable income they will have over the months ahead and the emergency budget and inflationary pressures such as rising food and petrol costs are adding to this worry.

U.K. house prices dropped again in July and will, probably, struggle to gain for the rest of the year. Prices in England and Wales rose 0.1% from June, when they fell by the same amount. Values are up 8.1% from a year earlier to an average £220,685. The decrease in house prices in July was the first since February and came as the number of transactions rose 11% from June to about 72,100 as more people put their properties on the market.

Regional data for June showed the drop in average prices across England and Wales was led by a 0.5% decrease in the Yorkshire and Humberside region, values in London fell 0.4%.

Bank of England governor Mervyn King believes it will be a long time before the economic outlook will be considered “normal”.

Wider economic problems around the world underline the fact that we cannot be confident that the recovery in demand, output and employment  in the UK will be sustained.  The fiscal tightening measures proposed by the Government will not choke off recovery, but it will slow economic growth over the next two years.

Of course it is encouraging that we have learnt recently of the strong 1.1% estimate of GDP growth in the second quarter, however we must be careful not to read too much into one number.  We continue to face the challenge of rebalancing the economy away from consumption towards net exports and raising our national savings rate.

The new coalition’s plans to cut the deficit are certainly ambitious but with the additional tightening set to come in the second half of the parliamentary term, the recovery should be firmly entrenched and the economy should be able to deal with the headwinds from the Budget.

On the assumption that the government is able to implement the overall reduction of £40 billion set out in the budget, the UK growth is likely to  struggle to reach 1% this year but should gradually speed up in the following years to give the UK a high-quality recovery based on trade and investment.

According to Ernst & Young base rate will remain at a record-low 0.5 % until the end of 2013. They said it would be necessary to keep base rate low in order to offset the effects of the Government’s spending cuts and to prevent inflation falling below 1%.  If this forecast is correct should you consider how your savings are invested?  Is cash still a good option or are other low risk, higher yielding products more suitable for some of your savings?

In October 2011 the government is proposing to scrap the default retirement age and has launched a consultation process about scrapping the rule.

Currently employers are able to force an employee to retire at the age of 65 without paying any financial compensation but they must hold a meeting with the member of staff concerned to discuss their plans at least 6 months prior to their 65^th birthday.

 “Forced retirement makes you feel pretty rotten, as if you’re stuck on the shelf and put to one side”  said John White, 70, a retired postman.

Some campaigners are delighted with this news – Rachel Krys of the Employers Forum on Age said, it was “really unfair” that people had been forced out of jobs because of their age.  “We have to stop these blunt discriminators,” she added.

The charity Age UK, which has led the campaign to end the default retirement age, also welcomed the government’s plan.  “We have fought a four-year campaign to achieve this historic decision so Age UK is absolutely delighted that the government is finally setting a clear date for the abolition of this arbitrary and unfair law,” said Michelle Mitchell, Age UK charity director.  “Everybody stands to win from scrapping forced retirement. People over 65 will have full employment rights for the first time. The economy will benefit from older workers’ precious skills and experience and their increased buying power.

Benefits

For the Government – it will reduce the unemployment figures as there are many who would choose to work past 65 meaning more people filling jobs which might otherwise remain unfilled whilst also easing the burden on state pensions.

It will also give workers more freedom of choice. As people tend to live longer these days and are in better health overall, many people would actually prefer to remain active and continue to work for both the social interaction work provides and their desire to still contribute their skills to a particular job or career.

Perhaps a better reason is financial planning as many people find that only by continuing to remain in employment, be that full or part time, can they continue to maintain a reasonable standard of living and not simply to survive on a basic state pension.

We would recommend that people plan as early as possible so that they are able to retire comfortably and not just survive.

Apart from the obvious one for those still blessed with the option of the ‘Bank of Mum and Dad’, who do you turn to for a quick, short-term loan?

Payday loan companies thrive on high interest rates and huge APRs, but some people love them.  Personally, I think I’d be put off by being charged an effective interest rate of 458% for borrowing £200 for a couple of weeks when my car broke down, but that’s not the case for everyone.  Even the Office of Fair Trading has just finished looking into the payday loan market and has concluded that the market works ‘well’ and that there is no need to put caps on the charges involved.

I personally don’t entirely agree with this.  It is true that the charges are made clear – if you look on the website of say Wonga and you will see just how much you will be charged for however much you borrow.  The total you will repay is clearly stated, as is the typical APR – 2689%.  So that’s all good, honest and above board.  If you need money in real hurry – and are able to pay it back before things slip away from you – it’s a straightforward way to borrow money.

However, if you aren’t absolutely desperate; it’s a totally mad way to borrow money!  Wait for things until you have the money put away for them is the most responsible way of spending.  This is not always the most practical though is it?  What about when the car breaks down, for example.  What are the alternatives?

Credit cards, authorised overdrafts all have a part to play.  Some more than others depending on your arrangements with your bank.  Starting with the latter, authorised overdrafts have an average interest rate of around 13-14% (with the exception of banks like the Halifax Bank of Scotland and Lloyds, which is soon to introduce a monthly fee).  Admittedly, unauthorised overdrafts, or going over your overdraft limit, can cost you much, much more and may even make the payday loan a more reasonable option.

And so to credit cards.  If you have the right card, you can easily borrow £200 for 20 days at not cost at all.  If you pay your bills off in full every month, you shouldn’t have to pay any interest on most credit cards.  If you need money for more than 30 days, you can still find some cards offering 0% rates on new spending for the first 12 months of holding them.  The downside to a 0% card is that after 12 months your deal will run out and you’ll want, or need, to move on.  In that case, you may find a low APR card, which you won’t need to change after 12 months, more interesting and easier.  One that I know of has an APR of 6.9% – which in the context of short-term loan rates sounds good to me!  Just make sure that you don’t use one to withdraw cash to pay the garage with – otherwise there will be an instant fee, 2.075% in the case of this particular card, and then a rate of 27.95% from withdrawal until you pay it back – no interest-free period.  It is, however, still around a tenth of what you’d pay with a payday loan.

Even the credit cards aimed at those with bad credit are still a ‘cheaper’ option.  The Aqua card for example.  It charges an APR of 35.9%, but no interest is charged if you pay in full by the payment date, and it is still less than payday loan rates.

Remember, there are choices, even during a recession.  So, before undertaking any kind of loan or credit card, there are two things that you absolutely must do.

1.       Shop around and,
2.       do your sums!

Pre-Budget Report, 9^th October 2007 – CGT flat rate of 18% for gains on non-business assets made on or after 6^th April 2008.

6^th April 2010 – income tax rate of 50% for those with incomes in excess of £150,000.

This all adds up to a differential of 32% for those individuals.  Was this sustainable?

The new Coalition Government seemed to put the writing on the wall for this state of affairs with their document entitled “Our programme for Government”, published on 20^th May 2010.  It included the sentence:

“We will seek ways of taxing non-business capital gains at rates similar or close to those applied to income, with generous exemptions for entrepreneurial business activities.”

Just what did that mean?  Speculation began.  Well, we’ve now had the Emergency Budget and what we’ve ended up with wasn’t as bad as some commentators thought.  The position is now as follows:

• The effective rate of CGT for gains qualifying for entrepreneurs’ relief will remain at 10%.  However, the lifetime limit on gains which qualify for entrepreneurs’ relief will increase from £2 million to £5 million for disposals on or after 23^rd June 2010.
• The rate of CGT on gains made by individuals, personal representatives and trustees before 23^rd June 2010 remains at 18%.  These gains will not be taken into account in determining the rate(s) at which gains arising to individuals on or after this date should be charged.
• For disposals made on or after 23^rd June 2010, the rate of CGT will remain at 18% for individuals whose total income and net gains when added together fall within the basic rate income tax limit.
• A rate of 28% will apply to gains made by those who are above the basic rate limit.
• Therefore, some people will pay tax at 18% on part of their gains and 28% on the balance.
• The annual exemption for 2010/2011 will remain at £10,100 for individuals and £5,050 for most trusts.
• For trustees and personal representatives, the rate is increased to 28% for gains on disposals made on or after 23^rd June 2010.

All of this means we have gone back to a system that is similar to the one that we had before 6^th April 2008, in that gains are added to an individual’s income as the top slice, and the rate of CGT will depend on whether the total of the income and gains is within or in excess of, the basic rate income tax limit.  This time however, there is no taper relief and the indexation allowance is no longer available.  Meaning that the gain after applying the annual exemption is taxed at the flat rate of either 18%, 28% or a combination of the two where:

• part of the gain falls within the basic rate income tax limit, and
• part is in excess of that limit.

The increase in the lifetime limit for entrepreneurs’ relief was very welcome for that type of person.  Entrepreneurs have had a good few months.  Following the increase in the limit from £1 million to £2 million, announced in the March Budget, the limit has now risen to 5 times the level that it was on 5^th April 2010.  This could be beneficial, as the less tax there is to pay on the sale of a business means there is more capital to invest in appropriate tax wrappers.

What other opportunities are there now?  Well, inter-spouse/civil partner transfers are back as far as tax planning is concerned.  Prior to these changes, the only point in transferring assets to a spouse/civil partner from a CGT perspective was to ensure that both annual exemptions could be utilised.  This is still important, but now an unconditional transfer of assets from a higher rate or additional rate taxpayer to a basic or non-tax paying spouse/civil partner will result in a tax saving on a subsequent disposal by the recipient.

Another area that should be looked at is the single premium bond versus collective investments.  An increase in the rate of CGT will make bond investment look more attractive, in spite of the CGT planning opportunities mentioned above.  The reduction in the basic rate income tax limit which will be introduced from 2011/2012, as a result of the increase in the personal allowance to £7,475, will also make the need for independent financial advice greater than ever.  It is anticipated that this increase will cause an extra 700,000 individuals to become higher rate tax payers.  Use of pension contributions could have a double benefit here as this will effectively provide a person with more basic rate band and possibly also result in a lower rate of CGT being payable.

Finally, the introduction of the 28% rate for trustees and personal representatives will make it even less attractive for trustees to hold equities direct.  This is because every disposal which generates a gain in excess of the annual exemption (£5,050 for most trusts) will produce a 28% tax liability.  The popularity of multi-manager funds may increase but this higher CGT rate will make single premium bonds look even more attractive for trustees of discretionary trusts and accumulation and maintenance trusts than they already did before.

So, even more reason to seek an independent financial adviser for tax planning, estate planning and investment advice.

I watched the Emergency Budget with anticipation to see if and how the pensions world would suffer.  Before the Election we had several parties with differing views on pensions and we ended up with a Coalition not knowing how their policies would eventually look.

I came away from the TV thinking that there wasn’t much in the budget about pensions.  But now I realise there was – although mostly subject to consultation.

• There was confirmation that the basic state pension will be increased each year by the greater of the increase in inflation, the increase in national average earnings and 2.5% per annum.
• There will be a consultation on the possible repeal of the high income excess tax relief charge (as proposed by the last Government) and its possible replacement by a reduction in the Annual Allowance to between £30,000 and £45,000.  Any change must deliver the same savings to the Treasury.
• Confirmation of a review of the timescale for increasing the State Pension Age to 66 – this review has already started.
• A review of the age 75 rule.  There is no requirement to buy an annuity at age 75 but there will be a review of the options available.
• Confirmation that the default retirement age of 65 will be removed.
• The introduction of legislation to enable the National Employment Savings Trust (a compulsory pension scheme for employers and staff to be introduced soon), to be treated as an occupational scheme and therefore able to benefit from normal tax reliefs.
• Confirmation of public service pension provision to be undertaken by the Public Service Pensions Commission.

It’s also worth noting that confirmation was given that Employer Financed Retirement Benefit Schemes (EFRBS) are within the scope of proposed legislation that will take action to consider arrangements which use trusts to avoid restrictions on pensions tax relief.  There will also be consideration of a general anti-avoidance rule (GAAR).

So, lots of changes, but quite what they’ll be, we will have to wait and see.  It is clear that we should all encourage a savings culture, as we all want our retirement to be an enjoyable period.  You should contact an independent financial adviser if you need any pensions advice.  Or contact us by phone: 01582 839280 or email.