As a result of these changes, many investors have decided to open SIPPs which have become a conventional way to save for retirement.

Transcription

1 MANAGING YOUR UK PENSION Introduction The UK Government amended the pension laws in the UK on 6 th April 2006 on what is commonly referred to as A-Day. These changes resulted in significant opportunities and benefits for working individuals to increase their pension contributions and pension assets. The changes allowed for most tax payers to open up Self Invested Personal Pensions (SIPPs) and take control of their pensions for the first time. In a SIPP investors have a wider variety of investment choices compared to a standard personal pension while benefiting from the tax relief offered by such plans. In most cases, SIPPs also provide investors with monthly or quarterly reporting and online access to view accounts in real time. As a result of these changes, many investors have decided to open SIPPs which have become a conventional way to save for retirement. How SIPPs work There are two ways to create and fund a SIPP. 1) New contributions; or, 2) Transfer of older pensions A SIPP allows investors to move away from traditional pension arrangements with limited investment options, infrequent reporting and no investment advice. The Basics Like personal or stakeholder pensions, SIPPs have contribution limits and retirement or distribution options. In general there are two ways to make a contribution. Investor Contributions If an investor makes a contribution, the SIPP trustee communicates with the HMRC, who in turn deposit an additional 25% of the value of the contribution directly to the SIPP. If the investor is a higher rate tax payer, then they can claim the contribution on their tax return and receive a tax rebate equivalent to another 25% of the contribution amount. Employer Contributions If your employer makes the contribution, it is normally made before taxes are deducted which avoids accounting for income tax, National Insurance Contributions and waiting for the tax refund after filing your tax return.

2 At some stage between age 55 (or 50 until 6 th April 2010) and 75 you can convert the portfolio into a 25% tax-free lump sum and a taxable income (see Options at Retirement section). SIPPs Investment Flexibility An important feature of SIPPs is their investment flexibility. The SIPP itself is merely a tax-efficient wrapper over your investments. You can make many different types of investments within the wrapper, including funds, shares, bonds, gilts, futures and options, commercial property and more. In this respect SIPPs are superior to a personal pensions and stakeholder plans in the investment choices they offer. Stakeholder pensions generally have low charges but tend to offer only a limited choice of funds. Traditional personal pensions tend to offer a wider choice of funds - anywhere between a dozen and several hundred - but can carry significant charges, particularly on older plans. Typically both of these types of pension are run by insurance companies, which generally offer only their own in-house funds or a limited selection from other fund managers. This limits investment choice. Whilst a single company may have expertise in one particular area, it is unlikely to be the best performer across all fund sectors. SIPPs offer the widest possible choice of investments, allowing investors to select funds and investments from across the market. Some SIPPs also allow you to invest in commercial properties, such as shops or offices. A SIPP can borrow up to 50% of its own value towards such a property purchase. Residential property is not allowed, unless this is through a property fund, and neither are racehorses, classic cars, art or wine. Is a SIPP right for you? SIPPs aren t for everyone. Some investors do not want the investment choice, while others may already have adequate pension provision through an occupational plan. But those who like the idea of taking responsibility and control of their pension plan should be attracted by the investment flexibility on offer. If you are starting a personal pension for the first time with a nominal contribution, you should look at all options. If investment choice and flexibility are not important to you, and your contributions are going to be low, then a stakeholder pension is likely to be a cheaper option than a SIPP.

3 What are the tax advantages? Contributions From a UK perspective, SlPPs have the same tax benefits as other personal pensions, with up-front basic-rate tax relief added by the government. For every 80p you pay into your pension, the government adds another 20p, boosting it to a gross contribution of 1.This basic-rate tax relief is claimed by your SIPP provider, and will be added into your pension account automatically. Almost everyone under 75 who contributes to a SIPP qualifies for this tax relief, even children and other nontaxpayers. Higher-rate taxpayers enjoy even greater tax relief as they can claim back up to a further 20p of every 1 gross contribution through their tax return or via their local tax office. This means, for example, that a 10,000 contribution to your pension would ultimately cost you 8,000 if you are a basic-rate taxpayer, and from as little as 6,000 if you are a higher-rate tax payer. In addition to the up-front tax relief the investments within your SIPP will not be subject to UK capital gains and income taxes, although taxes already deducted from dividends cannot be reclaimed. Employer contributions are paid gross, however if an employer pension contribution ranks as a valid business expense, it can be offset against the taxable profits of the business. In addition, any contribution an employer pays on an employee s behalf should not count as a taxable benefit so should not be liable to tax or National Insurance. Most Americans living in the UK pay more in income taxes to the HMRC than they are paying annually to the IRS. The IRS describes this surplus as Foreign Tax Credits (FTCs). These FTCs are only valuable if you can use them to reduce your taxes and a SIPP is an excellent way to do this. Essentially, your SIPP contributions lower your UK taxable income but are usually not fully offsettable against your US taxable income. The most tax efficient SIPP contribution is the point whereby you reduce your UK income to the point where your UK and US taxes are equivalent. For many investors this may be a difficult calculation, so we would recommend discussing this with your financial or tax advisor. The right amount of contribution essentially eliminates your FTCs and gives you basis in your SIPP from the IRS s perspective. This is extremely valuable as you will see in the later section that discusses distributions. If you are UK Resident and Non-Domiciled (and not American), you will simply get tax relief on your contribution like everyone else and don t have to worry about tax in your home country (in most cases). This is because most countries do not tax individuals based on citizenship but on residency (please check your personal situation with your tax advisor).

4 SIPP growth From a UK perspective, during your working life your contributions receive tax relief and build up a pension fund which should also benefit from the growth in the investment portfolio over time. For American tax payers it is not that simple and there are a few different possibilities: 1) Some of the tax advisors we have spoken with suggest that the SIPP is treated by the IRS as a Foreign Grantor Trust. If this is the case, then the growth is taxable in the same way any other of your investment accounts would be and subject to Long Term Capital Gains, Short Term Capital Gains, Dividend, Income tax rate, etc. If so, you acquire basis not only on your contributions but also on the growth when you come to make a distribution. For many people it is more helpful to pay a lower rate of tax annually (such as Long Term Capital Gains tax or Dividend tax rates which are currently 15%) as opposed to deferring the growth until it is distributed and paying Income tax (currently as high as 35%). This option would require an additional annual filing on your tax return (form 3520) and your financial advisor would need to file an SS4 form to get the SIPP an EIN number so that the IRS can keep track of the Foreign Grantor Trust/SIPP. If you are subject to this scenario, it is important to avoid investing in non-us registered mutual funds or other collectives as these are Passive Foreign Investment Companies (PFICs) and will be taxed inefficiently from a US perspective. For most of our clients, we recommend using a SIPP Trustee and Financial Advisor who is familiar with this kind of SIPP and investing in non-regulated collective investments (such as US mutual funds, ETFs, Hedge Funds, etc.). Investing a SIPP in a Deferred Variable Annuities (DVA) may make sense for investors, particularly those who are very young or those who will be in a lower tax bracket at retirement. In general, due to the additional cost and illiquidity characteristics of a DVA, a young investor would need to maintain above average rates of return for many decades for this option to be cost effective. 2) Other tax advisors suggest the SIPP will be treated as a Foreign Pension and the growth (not the contribution if FTCs are used) is taxed at the investor s highest income tax rate when a distribution is made. If an investor expects to be in a lower tax bracket when a distribution is made, then this possibility may be more attractive. Under this scenario, investors can invest in PFICs, US Mutual Funds, Offshore Funds, etc. Investors should speak with their tax advisors to determine which of these options is relevant to their own personal situation. Some advisors may suggest the determining factor is based on who (the investor or employer) makes the contribution. A popular view is that option 1 prevails if the investor makes the bulk of the contributions and option 2 if the employer makes the majority of the contributions. For UK Resident and Non-Domiciled (and not American) individuals, tax is deferred on the growth of a SIPP until funds are distributed.

5 Taxes on Distribution In the UK you can normally take up to 25% of your fund as a tax-free lump sum between the ages of 55 (or 50 until 6 th April 2010) and 75. The rest must be used to provide a taxable income (see the later section entitled What are my options at retirement for more details). If you die prior to taking retirement benefits, the fund can be used to provide a taxable income for your dependants or can normally be paid as a lump sum, free of tax, to your nominated beneficiary. However, if you are no longer a UK resident when you make the distributions you may not be subject to UK taxes on these distributions. You may, however, be subject to taxes on the distribution in your new country of residence (please check this with your international tax adviser). From the IRS s perspective, you will most likely have basis on your contribution and potentially the growth in your SIPP while you were UK resident (see section above) and you would need to pay income taxes only on the value above your basis at your regular income tax rate. If you are a UK Resident and Non-Domiciled (and not American), you can potentially withdraw your pension tax free if you are not a UK Tax Resident when you make distributions. Depending on where you are resident from a tax perspective when you retire (and make distributions) the rate of tax on your distribution will vary please speak with your international tax advisor about this. When you leave the UK and cease to be a resident for tax purposes, be sure to file form R85 upon your departure. This whitepaper is based on our current understanding of the rules and regulations and these are subject to change. The exact relief you are entitled to will depend on your individual and personal circumstances and as US national you should seek advice from your tax advisor in this respect. Who is eligible? The rule change on 6 th April 2006 means that nearly everyone (including children) in the UK is now eligible to take out a SIPP or transfer an existing pension into one. The rules have been relaxed so people can pay into occupational and personal pensions at the same time. Previously, there were restrictions if you were a member of an occupational pension. To benefit from tax relief on contributions up to age 75, you need to be resident in the UK, or be a Crown Servant serving overseas, or their husband, wife or civil partner. You can also benefit, even if you have not been resident in the UK for up to 5 years, if you were resident when you took out the SIPP. lf you meet these basic requirements you can usually pay in at least 2,880 per tax year, which with basic-rate tax-relief is boosted to 3,600 gross, whether you are a taxpayer or not. This means that children, retired people, and non-working carers or parents can build up a pension pot.

6 How much can I save annually? Since 6 th April 2006, unlimited contributions are allowed, but tax relief will only be given on the higher of 3,600 or an amount up to 100% of "relevant UK earnings" where this is a personal contribution. Generally, you will have relevant UK earnings if you have UK earnings, other than pension, savings or investment income. Each year there is an annual allowance on contributions; which for 2008/9 is 235,000. This allowance will rise in steps to 255,000 in the 2010/11 tax year. Where the total contributions (personal and employer) exceed the annual allowance you will be taxed on the excess at 40%. It is also possible that you could be affected by this if contributions in two separate tax years exceed one year's annual allowance. What is the lifetime allowance? There is a lifetime allowance of 1.65 million (2008/9), which applies to an individual s entire pension savings. This will rise annually to 1.8 million in the 2010/11 tax year, when it will be reviewed again. You must also include your Defined Benefit plans in this calculation. In general you take your defined benefit and multiply by 20. Add this figure to the value of all your pension savings to calculate your current balance. Should your total pension benefits taken exceed the lifetime allowance, they will be taxed with a lifetime allowance charge of up to 55% on the excess amount. If your pensions were worth more than 1.5 million on 5 th April 2006, or you have not made any further contributions to them after 5 th April 2006, you can take steps to protect them from the lifetime allowance charge. What happens if I have too much invested in pensions? There are two main options to protect your fund: Enhanced Protection is available to anyone, regardless of the size of their pension. It allows people to protect not only the current value of their pension savings, but also to protect the full value of future investment returns as well, without incurring a tax penalty. Under Enhanced Protection, if you make any further contributions to your pension after 5 th April 2006 the protection will be lost or cannot be claimed. lf you are building up benefits in a final salary scheme, you should check with your scheme administrator whether this will prevent you claiming Enhanced Protection.

7 Primary Protection is available to people whose pension funds were valued at, or over, 1.5 million on 5 th April It "protects" the value of your pension already accrued up to 5 th April 2006 and allows it to grow modestly in line with the lifetime allowance without triggering any lifetime allowance charge. Any fund above the amount protected when benefits are taken will be subject to the lifetime allowance charge, either paid at 55% on lump sums, or 25% where a taxable retirement income is taken. It may be possible to claim both Primary and Enhanced Protection and in some cases may be advantageous to do so. You need to register your pensions for protection with HM Revenue & Customs by 5 th April 2009.The above is a brief summary of a complex area. If you think you may be affected or need to register your pensions for protection, it is important to seek professional advice as soon as possible. What are my options at retirement? During your working life you build up a pension fund, receiving tax relief on your contributions and growth on the investments held in the SIPP. At retirement, or from age 55 (or 50 until 6 th April 2010), you can normally take a tax-free cash lump sum equivalent to 25% of the fund at that time. The rest of your fund can be made available to provide a taxable income. There are a number of different options you can choose to provide this income, outlined briefly below. The options If you are a UK tax resident when you make the tax-free distribution you can either use the remaining fund to buy a lifetime annuity, which pays you an income for the rest of your life, or you can draw an income directly from your SIPP. You will need to have set up your retirement benefits by your 75 th birthday. However since 6 th April 2006 you don't have to set up an annuity at age 75. You have the option of taking an Alternatively Secured Pension (ASP) instead of an annuity (see later section) if you do not want to buy an annuity at that point. Lifetime Annuities An annuity is an income for the rest of your life. Annuities come in two main varieties: conventional, where income is fixed, inflation-linked, or set to increase by a fixed percentage each year; and investment-linked, where income rises or falls depending on the performance of underlying funds. Conventional annuities are secure, however investment-linked annuities are like other products that are exposed to the equity markets and are therefore more risky. Once you have bought an annuity, the original pension fund can no longer be inherited by your family when you die (unless you have chosen value protection - see next page). However, it is possible to buy joint annuities which will continue to pay out to a spouse or partner if you die before

8 them, or to buy an annuity which is guaranteed to pay out for up to ten years, even if you die within that time. Value Protected Annuities These pay out any unused capital if you die before 75. The amount paid will represent the difference between the fund used to buy the annuity and the payments made so far, and will be taxed at 35%. They are more expensive than a simple lifetime annuity due to the cost of the value protection. lt is possible to protect only some of your fund, for instance choose 50% value protection. Income Drawdown (Unsecured Pension) This allows you to continue with your investments, after taking any tax free cash, while drawing an income from your fund. You can use income drawdown up to the age of 75, at which point you can buy an annuity or move to an Alternatively Secured Pension (see later section 13). Death benefits tend to be better than with an annuity, as if you die while in drawdown the remaining money can be used to provide an income for your dependants, or can normally be paid as a lump sum, subject to a 35% tax charge, to your nominated beneficiary. The maximum income limit is intended to be in the order of 120% of the income available from an equivalent conventional single life, level annuity. There is no minimum income that must be taken. There are HM Revenue & Customs restrictions if you wish to continue contributions once tax-free cash is taken. Limited period or short-term annuities can be bought within an income drawdown (unsecured pension) fund and can have a term of up to five years, providing they end before your 75 th birthday. The income will be paid to you directly by the insurance company, but must still be taken into account when calculating the maximum income level from your unsecured pension. These annuities will have no value after the term. Phased Retirement You don t have to convert your pension fund into an annuity or income drawdownin one go. Instead you can split it into segments and convert the segments gradually, receiving a series of tax-free cash payments and an increasing income, until the fund is fully converted. Alternatively Secured Pension (ASP) Since 6 th April 2006 you don t have to buy an annuity by age 75. Instead you can choose an Alternatively Secured Pension. This works rather like income drawdown, but for people aged 75 and over. ASP plans will not pay out tax-free cash. If you want to take tax-free cash, this has to be taken from income drawdown first (before you reach age 75).

9 The income you can take must be between 55% and 90% of an amount broadly equivalent to a conventional single life level annuity at age 75, and will be reviewed every year as if you were still 75. lf you die with an ASP and have dependants, the fund must be made available to provide them with a taxable income. If you have no dependants the value of the fund will be paid to a charity free of Inheritance Tax. Things to bear in mind Remember that investments should be held for the long term as they can fall as well as rise so you could therefore get back less than you invested. As you approach retirement you should reduce your exposure to volatile and riskier investments in preparation for securing your retirement income. Disclaimer All expressions of opinion are subject to change without notice and are not intended to be a guarantee of future events. This document is for information only and does not constitute a solicitation to buy or sell securities. Opinions expressed herein are not intended to be a forecast of future events or a guarantee of future results or investment advice and are subject to change based on market and other conditions. Past performance is not a guarantee of future results. Diversification does not ensure against loss. Although information in this document has been obtained from sources believed to be reliable, MASECO LLP does not guarantee its accuracy or completeness and accept no liability for any direct or consequential losses arising from its use. Throughout this publication where charts indicate that a third party (parties) is the source, please note that the source references the raw data received from such parties. Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall. Bonds face credit risk if a decline in an issuer s credit rating, or creditworthiness, causes a bond s price to decline. High yield bonds are subject to additional risks such as increased risk of default and greater volatility because of the lower credit quality of the issues. Finally, bonds can be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made. Alternative investments referenced in this report are speculative and entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns on transferring interests in the fund, potential lack of diversification, absence of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds and advisor risk. In the UK, certain services are available through MASECO Financial ( MASECO ), 12 New Fetter Lane, London, EC4A 1AG, which is authorised and regulated by the Financial Services Authority for the conduct of investment business in the UK. MASECO is an SEC Registered Investment Advisor in the United States of America.

10 US Treasury Department Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.