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Opinion: The tax and pensions racket

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24th Feb 2005
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John Sartoris, private practitioner and a regular contributor to TaxZone and AccountingWEB, argues that the new pensions tax regime is designed to generate fees for the pension industry and tax for the Government.

We generated both heat and light when we debated Personal Pensions and self-invested personal pensions (SIPPs) in the Any Answers section of AccountingWeb the other week*.

But we really only had space to scratch the surface of the subject and no one will be surprised that there were respected contributors arguing on both sides of the controversy.

The financial press have also recently run stories on this topic, with emphasis on the new tax regime that implements Gordon Brown's "Simplification of the Taxation of Pensions" from April 2006.

Much of the press comment deals only with the apparent benefits and there is suspicion that some of it is promoted by the Pensions Industry and IFAs, keen to drum up business and generate fees and commissions. The very real downsides are glossed over or even ignored altogether.

For example, there is much excitement because it will be possible to put residential, rental property into a SIPP and not only will the rental income and capital gain roll up tax-free but, also, the cost of the property may be deductible for income tax, saving up to 40%.

Sounds good. But what is not mentioned is that, once the property is in the SIPP, it could cost up to 70% of its market value in tax charges to get it out again, if you need the cash or want to have something to leave in your will.

Better, surely, to own the rental property yourself. The rents will be subject to income tax at up to 40% but the maximum capital gains tax is likely to be only 24% after ten years ownership (and only 10% for business properties after two years) and it is tax on the gain not the full proceeds, as is the case with the 70% Pension Tax charge.

There is no capital gains tax at all if ownership is retained until death, although Inheritance Tax may then kick in, but that is still only 40%, with a current allowance of £263,000.

A conspiracy theory
The conventional wisdom is that the fiendishly complex 136 sections and 9 schedules of Finance Act 2004 that implement the "Simplification of the Taxation of Pensions" are a good deal.

But who will really benefit? The Inland Revenue and the Pensions Industry (strange bedfellows, to say the least) say pension savers will. Well they would, wouldn't they?

The Pensions Industry actually backed the Inland Revenue's proposals with surprising unanimity and enthusiasm. You do not have to be a complete cynic to suspect their motivation was simply to encourage savers to continue to buy pensions despite the very serious drawbacks of the new regime.

But what motivated the Inland Revenue and the Treasury? What is not always seen is that it is not only savers who hope to get more out of pension funds than they put in. The Treasury also craftily calculates that it will rake in more tax on pensions paid out than it will have to give in tax relief on contributions paid in. Much more!

The underlying principle "tax relief on contributions paid in" justifies taxation of pensions paid out' is reasonable enough. But the Inland Revenue were not content to stop there. They had to add:

  • 40% tax charge on contributions over of the annual allowance (£215,000 for 2006/07);

  • 55% tax charge on benefits drawn in excess of the lifetime allowance (£1.5m for 2006/07);

  • 55% or 70% tax charge on unauthorised payments. These rates include the "Scheme Sanction Charge" and the "Unauthorised Payments Surcharge" and can apply to such simple transactions as just getting your original savings back.

How can the penal 55% and 70% rates be justified? Equity is surely fully satisfied if pension fund payments and contributions are symmetrically taxed and relieved at the same rate.

Pension tax charges should therefore be no more than 40%. Rates in excess of that mean not only asymmetry but also that pension fund assets actually suffer more than the maximum tax on the same assets held personally. Only avarice of the Inland Revenue and the Treasury can explain that.

Alternatives
Why would anyone want to expose their hard-earned savings to minimum 40% and maximum 70% tax by putting them into the straitjacket of a Personal Pension or SIPP? It is not as though there are no alternatives with considerably more flexibility and considerably lower tax exposures.

PEPs and ISAs for a start. In converse to pensions, the principle here is "no tax relief on contributions in, therefore no tax on payments out", no matter how much profit or gain you make or how much you pay out to yourself.

Second, direct investment in Unit and Investment Trusts. It is often overlooked that investments inside these entities roll up tax-free, the same as in pension funds. You can cash in easily whenever you want and tax is only 24% after ten years ownership and it is tax on the gain, not the full proceeds as it is with pension fund taxes.

There is no capital gains tax at all on death, so there will be something to leave to the children (subject to IHT) if you don't spend it all yourself before you go.

Third, there is the already popular alternative of direct ownership of residential or business, rental property. The maximum capital gains tax charge is again likely to be only 24% or 10% on lifetime disposals and 0% on death (subject to IHT). And you have the security of owning the property 100% yourself as well as getting the rents.

What a racket
The truth is, Personal Pensions and SIPPs are rackets perpetrated by an unlikely and unseemly alliance between the Pensions Industry and the Inland Revenue. They are really nothing more than commission and fee generating machines for the Industry and tax generating machines for the Revenue. You are likely to be much better off owning your savings personally and looking after them yourself.

*Any Answers discussions:
Pension and property - 10 Feb
SIPPs - 8 February

John Sartoris

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Replies (7)

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By AnonymousUser
28th Feb 2005 15:59

What about the tax free lump sum?
There are 2 main benefits to pensions over Investment Trusts etc. predominantly the tax free lump sum whereby only 75% of the pension fund will be taxed at 40%, i.e. 30% tax. In addition, for more modest investors, the lifetime limit is unlikely to be a problem and there may well be a marginal tax benefit. Some of the tax may be only at 22% under current rules (or possibly 33% due to loss of age allowance) as only the wealthiest pensioners in the future will be higher rate tax payers unless annuity yields increase substantially. In addition, many higher rate taxpayers may be able to get 46.7% relief due to child tax credits!

ISAs are a better investment for many, but the amount is limited. I agree that pensions are a poor investment for those not able to invest enough to get them well above the guaranteed pension limit. Those for whom pensions are appropriate are likely to need to invest above the ISA limits for a reasonable retirement, particularly as few save consistently throughout their working life.

You suggest that taxing capital gains on investments as opposed to the entire receipt for pensions is unjust. I would say that this is a reasonable compensation for upfront tax relief on the investment. This means that, assuming constant tax rates, the extra tax paid on exit relative to that received on entry is a tax on the growth (ignoring the 2 benefits above). This seems equivalent to the tax on the gain with no relief for the investment.

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By User deleted
27th Feb 2005 19:51

Written In Trust; IR & The Pension Industry?
Agree entirely, always have. I dont want your average pensioner paying tax. SIPP's will get the waffle mechants pedaling their lies again, and all the while there is a serious lack of commitment on the part of the individual to take out new pensions or increase premuims. Company pension scandals and poor investment returns, saw to that. SME people with savvy only take the company pension route now as the last resort. ISA's etc are a better bet.

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By AnonymousUser
01st Mar 2005 08:59

What about that 25% tax free lump sum?
The 25% tax-free lump sum is not a benefit. It is a concession so that you do not lose access to 100% of your pension fund capital. Instead, you loose access to only 75% of it! Additionally, if you don't take the 25% within 3 months of retirement, you loose access to it altogether

With Investment and Unit Trusts you retain 100% of your fund capital until you choose to sell any of it. Then, the maximum CGT is likely to be 24%, so you retain 76% of your fund capital compared to maximum 25% with a pension fund.

After taking the 25%, tax is charged on the subsequent retirement pension, not on the remaining 75% fund capital. Therefore, it is incorrect to say that 'the remaining 75%pension fund will then be taxed at 40% ie 30% tax'. The pension will actually be taxed at income tax rates of 40% or 22%.

It is true most people will not be affected by the lifetime allowance. But the 55% and 70% rate pension taxes can apply even when the lifetime allowance is not exceeded. For example, if you just try to get your original savings back you could lose 55% or 70% in pension tax charges.

If the ISA limit is a problem, the balance is better invested in Investment or Unit Trusts or property rather than a pension fund.

For many it will not be a problem at all. £7,000 a year for say 35 years is £245,000, plus gains could easily result in a fund on retirement of £400,000. That could produce a tax-free income of £24,000 a year which is equivalent to a pension of about £30,000 for a basic rate taxpayer and £40,000 for a higher rate taxpayer.

Additionally, you retain ownership of the fund capital itself (which you lose with a pension, subject to the 25% allowance).

You pay for the upfront tax relief on contributions not by paying the 55% or 75% pension taxes on capital receipts but by paying income tax on pension income. And you pay dearly!

The longer you live and the higher the pension the more income tax you pay. That is why the Treasury and Inland Revenue are so keen on promoting pensions while at the same time penalising access to fund capital so that you are obiged to use it to buy more pension income that generates more tax for them.

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By AnonymousUser
24th Feb 2005 16:17

55% and 70%

Where do those 55% and 70% tax rates come from?

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By AnonymousUser
24th Feb 2005 16:34

Those rates!!

The 55% rate is the FA 2004 s208 unauthorised payments charge of 40% + the s240 scheme sanction charge of (40% - 25%) = 15%: ie total 40% + 15% = 55%.

The 70% rate is as above, plus the s 209 unauthorised payments surcharge of 15%: ie total 55% + 15% = 70%.

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By andyprentice
25th Feb 2005 12:47

not all bad news?
some positives for pensions:

Potential IHT free transfer to children - OK you do have to die before taking benefits!

40% tax relief going in against possible 22% tax liability coming out - after tax free cash.

Anyone who is gong to hit the lifetime limit is likely to have other assets over the IHT limit, so holding assets personally is potential IHT problem.

Having a good pension income in retirement, may mean that a person can afford to give away capital (PETs) free of IHT.

The basic reason for having a pension of any kind is to provide income in retirement - anything that works to that goal has to be a good thing for most people.

other ramblings:
I do get concerned about residential property going into a pension although the 50% borrowing limit will limit the use of this by ordinary punters.

Commissions for pensions are mostly much less than they were some years back - I guess most IFAs etc would welcome clients wanting to invest in ISA's OEICs and the like.

As for commercial property in a SIPP - this used to be a good option - but since the changes to CGT and taper relief, I'm with John on holding it personally wherever possible - it gives freedom to do what you want with your own money.

PS Did you buy that house in Spain, John?

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By AnonymousUser
25th Feb 2005 15:22

Mis-selling Personal Pensions and SIPPs

Given what Sartoris says, a saver's after-tax position under the new regime from a Personal Pension or SIPP is likely to be worse than if had invested the same amount in one of the alternatives mentioned.

It therefore looks like anyone who sells a Personal Pension or SIPP that will be taxed under the new regime will be seriously exposed to a charge of mis-selling.

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