UK: Family Wealth Management - Spring 2011

Last Updated: 19 April 2011
Article by Smith & Williamson

Foreword

Keeping things simple?

The Budget and its aftermath often dominate the thinking of financial planners at the start of the new tax year. As always, there was much to absorb in the detailed Budget releases from HMRC. This year this included a proposal to remove 100 pages from the current tax code by abolishing some outdated reliefs. While this is welcome, is the Chancellor missing a trick to simplify tax further by merging income tax and NICs?

As we wave goodbye to another financial year, we're still facing a good deal of turmoil around the world – economic, political and the recent catastrophic events in Japan. We touch on these later in this issue of Family Wealth Management in our regular investment outlook report on global markets.

At home, we're facing up once again to the spectre of inflation, something that hasn't been a major factor in investment decisions for quite some time. We look in detail at the UK's 'perfect storm' of inflation shocks and offer some tips to protect your assets.

Also in this issue, we look at the cost of university education and the forward planning required as fees soar. There are yet more changes to pensions to absorb and we explain what they will mean. We also look at salary sacrifice, offshore pension schemes and the new rules to end disguised remuneration. Finally, we're very proud to celebrate some more award successes for Smith & Williamson – see back page for further details.

There were few shocks in the Budget, but let's put it into context.

George Osborne's second Budget had few shocks, although the reduction in the headline rate of corporation tax seemed to have been a well-kept secret. However the annual Budget must now be seen in the broader context of tax policy making.

The Government has introduced a new way of setting tax policy which includes a timetable for changes generally to be announced in a spring Budget, followed by a period of consultation during the summer, leading to the publication of draft legislation in the autumn. The Finance Act will then be signed off by the end of the calendar year and the new rules will apply from the following 6 April.

Many of the Chancellor's announcements will become effective next year or later after a period of consultation. Hopefully the new timetable will help the Government to achieve its objective of creating a more certain and stable tax system.

The Budget in context

Reflections on a new era of tax policy

Widening the tax net

It's important to remember that a number of changes in the income tax and national insurance contribution (NIC) rates for 2011/12 were announced last year, which means that anyone earning more than £42,475 a year will be paying more in income tax and national insurance from 6 April 2011.

Higher income taxpayers were already being taxed more heavily in the 2010/11 tax year. Those on £100,000 a year and upwards lost the benefit of the personal allowance, while those on taxable incomes of £150,000 upwards have also been paying 50% on income above this level. But there are too few top rate taxpayers to fill the Chancellor's coffers – hence the need to widen the net still further to those on 'middle incomes'.

Simplification?

Another essential ingredient in the Government's tax policy-making was the establishment of the Office of Tax Simplification (OTS). The OTS issued two important reports ahead of the Budget, reviewing 155 tax reliefs and the taxation of small businesses.

The Chancellor responded to the first report by proposing the removal of 100 pages from the current tax code by abolishing some outdated reliefs.

While the removal of reliefs which are now past their sell-by date is welcome, genuine simplification will require major pruning of the existing tax code. The OTS's report called for a complete overhaul of inheritance tax and, although nothing was said about this in the Budget, it is hoped that the Chancellor will respond on this point in due course.

Merging income tax and NICs?

The OTS's report into the taxation of small business underlined that the Government should consider merging income tax and NICs paid by individuals.

In his speech, the Chancellor noted that income tax and NICs have operated as two fundamentally different systems causing unnecessary costs for employers. He confirmed that the Government will consult on 'merging the operation of income tax and NICs'. The Budget report states that the contributory principle will continue and NICs will not be extended to individuals above state pension age or to other forms of income such as pensions, savings and dividends.

It appears, therefore, that the Government is backing away from a full merger of income tax and NICs, with a single rate of tax on earnings. Instead, it appears to be thinking of keeping the two taxes running in parallel but with identical definitions.

While this approach would improve the position slightly, the Chancellor is arguably missing a once-in-a-generation opportunity for a major simplification of the tax code by means of a full merger of the two taxes.

Putting fuel in the economy?

The Budget's main aim was to stimulate enterprise and so encourage growth and jobs. The Chancellor reiterated that he wanted the UK to appeal to global businesses as a location of choice. Positive signs have come from the chief executive of WPP who indicated that the company will consider relocating its headquarters to the UK, but it remains to be seen whether the reduction in the headline rate of corporation tax, and other reforms now underway, are sufficient to tempt more businesses to relocate here.

The Treasury published a supporting Budget report of almost 200 pages, but this was short on detail and will no doubt be followed by a flurry of consultation papers in line with the new policy structure.

Moving the goalposts

Yet more changes to pensions

2010 was a busy year for changes to the pensions regime. Last October, draft legislation was introduced limiting tax relief on pension contributions from 6 April 2011, and reducing the lifetime allowance from £1.8m to £1.5m with effect from 6 April 2012.

At the time, the Government indicated there would be consultation on the issue of individuals being forced to take an annuity from the age of 75. As an interim measure, the age of 75 was extended to 77 until new rules had been finalised.

In December 2010, new rules were announced to take effect from 6 April 2011. These change the options for generating pension income, and deal with the issue of taking an annuity at age 75. They also include changes to inheritance tax (IHT) on pension fund death benefits. There are no changes to the ability to take a tax-free pension commencement lump sum (PCLS).

The first major change is that there will no longer be a requirement to take benefits by a specified age. The tax free PCLS and pension benefits can be taken at any time from age 55. Secondly, the unsecured pension (income drawdown up to age 75) and alternatively secured pension (income drawdown from age 75) will be scrapped, and replaced with capped drawdown and flexible drawdown.

Capped drawdown

This will operate in a similar way to the unsecured pension. There are three main differences.

  1. Individuals will be able to continue in capped drawdown throughout their lifetime.
  2. The maximum limit on annual income will still be calculated by reference to government tables known as 'GAD rates', which broadly reflect the rate of a single life, level annuity at a given age. The limit will, however, be set at 100% of the relevant GAD rate for an individual's age. The maximum unsecured pension was previously based on 120%, while an alternatively secured pension was based on 90% of the rate for a 75 year old. The change will restrict the maximum income prior to age 75, compared with current rules, but is more generous thereafter.
  3. The maximum income will be reviewed every three years. At present, this takes place every five years in an unsecured pension and annually in an alternatively secured pension.

Flexible drawdown

Flexible drawdown offers a new approach compared with current options. As long as an income of £20,000 per year is secured, flexible drawdown will be available. Examples of secured income for this purpose are state pension, pension annuities and scheme pensions, provided the scheme from which it is paid has at least 20 members. Purchased life annuities and investment income, for example, cannot be included. Subject to securing this minimum income, there will be no restriction on withdrawals from the rest of the fund. Indeed, it will be possible to take the whole of the fund, subject to payment of income tax.

The flexible drawdown option may appeal to some who can secure the £20,000 income. It remains to be seen how many people will wish to withdraw the whole fund, particularly bearing in mind that:

  • there is potentially an income tax charge of up to 50% on funds withdrawn
  • it is very likely that, after income tax, the income generated from the capital withdrawn will be considerably less than that available through capped drawdown
  • funds held within the pension fund grow free of capital gains tax (CGT) and virtually free of income tax, whereas they will potentially be subject to both taxes if held personally
  • while tax at 55% will be due on the residual fund in the pension on death, funds held by the member will be subject to IHT at 40%, having already been subject to income tax when extracted from the pension.

Death benefits

If there is a residual pension fund on death, it can be paid out as a lump sum. In this case, the position will be:

  • if no benefits have been drawn and the member dies prior to age 75, the fund may be paid out without any tax
  • if no benefits have been taken and the member dies after age 75, the fund may be paid out to nominated beneficiaries, subject to a 55% tax charge; any taxfree lump sum entitlement that has not been taken will be lost, or
  • if the member dies while drawing the benefits through capped or flexible drawdown, the fund can be paid out to nominated beneficiaries, subject to a 55% tax charge; current tax charges are 35% for unsecured pension prior to age 75, and a combination of taxes totalling up to 82% of the fund on death after age 75.

Inheritance tax

The Government has simplified the current system, where IHT may be payable in certain circumstances. As long as arrangements have been set up correctly, IHT should no longer be payable on pension funds.

Comment

Most individuals with relatively small funds will still find purchase of an annuity the most appropriate option. Those who have built up larger funds will have some additional flexibility, and the decision to remove the obligation to take an annuity at 75 is to be welcomed.

While the tax increase from 35% to 55% if the fund is paid out on death of the member prior to age 75 is disappointing, financial dependants will still have the option of taking income from 100% of the fund, and the charge reflects the fact that pension funds are intended to provide retirement income for the member and financial dependants, rather than an inheritance.

There are still advantages and disadvantages to each option, so the decision on how to generate pension income from a fund continues to be complicated and requires consideration of personal income needs, provision for financial dependants, attitude to investment risk and tax. Professional advice to help make the right choice will therefore be key.

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