Pension planning

Pension planning

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Given that many 'one man band' companies are adopting a policy of minimal salary plus dividends to extract funds from the company, what is the impact on their pension planning?

Are they still able to contribute sufficiently into a pension?

What is the general consensus on this matter?
Dave Paveley

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By andymeeson
26th Oct 2005 17:31

It must be confessed
I agree with Peter on a number of broad issues.

"I suspect that it will be more practical if most SIPPs acquire shares in entities that manage the property investments. eg a very small and more personalised version of the large unitised funds currently available."

So do I. This is particularly so with regard to gearing: while a SIPP will be limited to 50% gearing, its underlying investment vehicle may borrow whatever it can. There is even the prospect of double gearing: the SIPP borrows to enhance its investment in a geared vehicle.

"Is the tax break really only worth 10% (40% x 25%)?"

Not really, no. The tax breaks on contribution, combined with the tax-free growth within the fund, combine to ensure that (over a suitable timeframe - never forget that pensions are a long term investment) the operable fund at vesting will be far greater than that provided by a taxed investment.

This will go a long way towards making up for the restrictions on how that fund may be drawn (and, yet again, we should never take our eyes off the fact that pensions are designed to yield a deferred income, so comparisons with 100% capital returns are inevitably somewhat skewed).

As SOGG says, follow the tax and NI all the way through (he didn't!)

For example, over a 20 year growth period with a bog-standard 5% growth, a pension fund will have grown to c. 1.46x the equivalent growth in a 40% taxed medium. This means, using SOGG's approach, a tax saving of [40% x 25% x 1.46] 14.6%. Add in the effect of tax relief on funding (such that a HR taxpayer only contributes 60p per pound of sum invested), and you get 24.3%.

Those numbers get better as the years roll on, and if you can get 7% growth the edge becomes 28.3%.

[Needless to say, it's all far more complex. To do a full comparison you would need to consider frequency and timing of funding, the true opportunity cost of tax charges, and a myriad of other factors. However, the broad thrust remains true. No other mechanism for generating deferred income can approach the SIPP for tax efficiency, and it can give a good account of itself against a number of capital-based investment vehicles.]

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By AnonymousUser
26th Oct 2005 16:20

The original question has been answered. But….
The discussion is now centred on whether it is worthwhile to invest in a pension.

If any investment is worthwhile then surely one with tax breaks has some merit. My example was slightly flawed but the point is still valid. Saving CTax on an employer pension contribution effectively allows more to be invested.

Per Andrew Meeson’s response to https://www.accountingweb.co.uk/item/146371/448

Is the tax break really only worth 10% (40% x 25%)?

Using a personal contribution of £50k for a high rate taxpayer with over £50K of income taxed at 40% (ie a salary of about £82k pa), the basic rate tax credit and the high rate tax repayment would produce £25,641.

Assuming a conservative 5% gross return on the fund of £75,641 over 20 years, it will grow to £200k, 25% is £50k and a 7% annuity is £14k pa.

Investing £50k personally for a high rate taxpayer using tax free funds such as ISAs over 20 years produces a fund of £132,665. A 7% annuity will only generate £9.3k pa.

From a pure retirement planning viewpoint the pension route would seem to be more attractive than ‘only 10%’.

I used Property in my example because I believe that with sensible use of gearing and an actively managed portfolio it ought to be possible to outperform average growth in incomes, which includes being aware of the economic fundamentals.

I had to look up arcane - mysterious, secret; understood by few – I agree that the new SIPP opportunities are understood by only a few but I believe every accountant should acquire an understanding about SIPPs if their clients are to be able to make informed decisions.

I suspect that it will be more practical if most SIPPs acquire shares in entities that manage the property investments. eg a very small and more personalised version of the large unitised funds currently available.

Proactive firms of accountants could help groups of clients to achieve this in conjunction with the relevant service providers.

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By wdr
26th Oct 2005 00:03

There is an old saying in German which translated means"Trees do
If you want to plan on the basis that house prices can indefinitely grow faster than the growth in incomes, you should not be surprised that your hopes will be dashed.

By way of a warning, in Japan house prices are today still lower than they were 15 years ago, and I do not believe that the position is much better in Germany.

The problem is not mathematics , but that gloomy science - economics

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By AnonymousUser
25th Oct 2005 21:39

Have I misunderstood something or could the following example re
Suppose you had £50k of profit and instead of salary and dividends your company paid £50k into a SIPP. Together with the SIPP Trustees tax claim the fund now has £64,103 (£50k/.78).

The SIPP Trustees can borrow up to 50% ie another £32,051 giving a total of £96,154 for investment.

House prices have increased at around 11% pa since 1930 according to the Office of the Deputy Prime Minister.

Using 11% as a compound growth rate and ignoring any rental yield after loan interest and other costs and assuming a 20 year term until retirement, which can be up to 75. Enter the following formula into Excel =96154*Power(1+11%,20) the answer is a pension fund of £775,233. (£113,703 in respect of the tax credit)

25% Tax free produces £193,806 (£28,426 in respect of the tax credit)

A likely annuity rate of about 7% of the remaining fund produces £40,699 pa (£7,959 pa in respect of the tax credit).

If the SIPP acquired shares in a company registered in a low or tax free jurisdiction together with a few other investors and the company had a rolling investment program taking advantage of locations with strong growth trends, is it likely that returns in excess of 11% pa could be achieved?

Is it possible that the offshore company could work with a more advantageous but comfortable gearing ratio of say 30/70?

At 15% pa compound and investing with a 30/70 gearing ratio the fund would grow to over £5m. A pessimistic 6% still produces over £800k.

If I have got it badly wrong please tell me as soon as possible. My contact details are on www.tmips.com

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By NeilW
25th Oct 2005 15:48

Depends
Pensions avoid National Insurance permanently for both employer and employee, which can be a big draw for anybody approaching 50.

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By Malcolm Veall
25th Oct 2005 14:58

Someone who actually agrees with me
Son of Grumpy Git, (can I call you SOGG?),

I have always said that pensions marketing is misleading - a SIPP is said to grow "tax-free" but really the tax is just deferred until the annuity is drawn, (apart of course from the 25% lump sum).

I have been answered that you save more tax now, as a high earner, than you pay later but I bet many pensioners living on their more modest incomes wish their pension was not taxed.

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By NeilW
24th Oct 2005 10:54

All change April 2006
After April 2006, there is effectively no cap on pension contributions (there is a cap on tax relief however, but it is high at £215K - or as commercially justifiable), so I would say there is little or no impact - assuming the rules stay as planned.

NeilW

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By User deleted
24th Oct 2005 16:29

Is it quite as cut and dried?
You should consider the impact of drawing substantial dividends. What does that do to share valuations, for example?
What makes you think you save substantial amounts one way rather than the other using pension contributions?

Follow through the tax and NI all the way.
The true tax saving for a higher rate taxpayer of money put into a pension pot is:-

a) 10% of the fund[40%*25%], as the balnce has to be drawn as a taxable pension.
Not a welcome message for those promoting the wonders of pension scheme planning.
and

b) some IHT shelter, but not as much as you think if the latest consultative paper is anything to go by.

c) the compound interest effect of tax deferred on the investement and capital gains made by the fund
and
d) not much else!!

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By andymeeson
26th Oct 2005 10:13

Problem with Mr Hool's assumptions
"your company paid £50k into a SIPP. Together with the SIPP Trustees tax claim the fund now has £64,103"

NO. Companies pay employer contributions gross, and there is no trustee tax claim. The fund has £50k.

As far as pension reform is concerned, the greatest danger (not a stab at you, Peter, this is exhibited all too frequently on AccountingWeb) is that people are tending to focus in on the complex and speculative elements without paying sufficient attention to the basics. In 90% of all client situations we will be encountering post 6 April, very little of the arcane stuff discussed here will have any relevance whatsoever.

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By AnonymousUser
24th Oct 2005 13:52

Thanks Neil ...
good to see at my age I can still sit through a lecture and miss the point! Mind you the guy that sat behind me and slept for nearly 7 hours (including lunch)probably missed even more!

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By NeilW
24th Oct 2005 13:11

Employee contributions
The 100% of earnings cap is for employee contributions, and again that is for tax relief purposes. There is no longer a legal bar on paying what you want into a pension, just not a lot of point.

If you have a small owner managed limited company you would probably be making employer contributions which is where the £215K/commercially justified amount comes in.

For example you should be able to pay a £40K employer pension contribution and a personal allowance salary and get corporation tax relief on the lot.

NeilW

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By AnonymousUser
24th Oct 2005 12:40

Please check my understanding
My understanding is that there will still be a limit on contributions (limited to 100% of earnings subject to the cap). As dividends will still not count as "earnings" then the low salary - high dividends strategy is still going to cause practical problems for those who want to invest significant sums.

This understanding came from a CPD course on Saturday, so if anyone disagrees then please tell me now before I spread the gospel to my clients!

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