Tax policy guidelines For adviser use only
Contents Tax policy guidance 3 Steps to be taken 4 Maximising tax allowances 5 Managing tax rates 7 Maximise tax privileged wrappers 9 Inheritance 9 Appendix 10 Laws and tax rules may change in the future, and the information here is based on our understanding in April 2017. Your clients personal circumstances also have an impact on tax treatment. Every person s circumstances will be different and require advice. Standard Life accepts no responsibility for advice that may be formulated on the basis of this information. No guarantees are given regarding the effectiveness of any arrangement entered into on the basis of these comments. 2 Tax Policy Guidelines
Tax policy guidance Your clients could be wasting up to 22,300 (2017/18) of tax free allowances this year by taking their retirement income solely from their pension. At the same time they could be reducing how much wealth could be left to their loved ones on death. The challenge is to undo a lifetime s worth of hardwired retirement savings habits. The key to achieving this is to demonstrate that an alternative approach, using a range of savings and investments held in different tax wrappers, can improve the sustainability of income in retirement while securing the best possible legacy on death from unused funds. The benefits of a tax policy framework For your clients Using a tax policy framework will help meet your clients spending needs in retirement in a tax efficient way and secure the greatest inheritance for their loved ones. This can be done by: 1. Minimising the tax payable on withdrawing funds by maximising the use of available allowances. 2. Limiting the effects of tax on future investment returns by making full use of tax privileged investment wrappers. 3. Future proofing their retirement strategy to ensure that avoidable future tax charges are not stored up. For couples this could also mean spreading savings and investments between each party to ensure both sets of allowances are utilised, doubling the amount that can be taken tax free. Married couples and civil partners can transfer assets (for example, shares, investment bonds) to each other without generating a tax charge on transfer. For your business Using a tax policy framework will help you to establish clear repeatable processes which aim to provide tax efficient income and investment growth for your clients in retirement, and will help you to: More clearly demonstrate the value of your advice. Improve efficiency by having repeatable processes, making tax planning strategies easier to implement. Reduce risk for your clients and your business. Tax Policy Guidelines 3
Steps to be taken 1 Ringfence emergency funds 2 Full portfolio used for retirement income 3 Maximise tax allowances 4 Manage tax rates 5 Maximise tax privileged wrappers 6 Consider inheritance implications 7 Review The key steps to achieve these objectives are likely to include: 1. Ensure sufficient funds can be accessed tax free in case of emergencies. This can be achieved by retaining sufficient funds within ISAs or by using tax free cash from uncrystallised pension funds. 2. Meet spending needs by considering the full range of your client s savings and investments, not just their pension savings. This could include withdrawing from capital resources rather than income alone. 3. Maximise the use of all tax allowances available. And if there are still unused allowances after the required income has been met, the excess can be used to top up tax privileged savings such as pensions and ISAs or to reset the CGT base cost. 4. Manage tax rates where required income exceeds the amount provided from available tax allowances. This could include using capital sources to provide income; taking capital gains in preference to income sources; or maintaining income within the basic rate band. 5. Maximise the use of tax privileged wrappers to reduce any tax drag on future investment returns by moving savings between tax wrappers in retirement. 6. Retain investments which will provide the greatest tax efficient inheritance for loved ones. This could include taking withdrawals from investments which form part of the estate for IHT before those which do not. 7. Review the tax strategy each year to ensure it continues to meet your client s aims and that any changes to tax legislation, rates, allowances and the client s personal circumstances are factored in. 4 Tax Policy Guidelines
Maximising tax allowances Maximising the use of tax allowances reduces the tax payable in retirement and improves the sustainability of your client s savings to meet their spending needs. For couples that could mean spreading investments between each party to ensure both sets of allowances are used and could double the amount that can be taken tax free. If there are still unused allowances after the required income has been met, the excess can be used to top up tax privileged savings such as pensions and ISAs. The key allowances and their impact on the tax policy are as follows: Income tax (for tax year 2017/18) 1. Personal Allowance Income of up to 11,500 per annum can be received free of income tax. This allowance is reduced once total income exceeds 100,000. Earned income (including pension and rental income) will use the allowance first. If not used the allowance will be lost. 2a. Savings rate band Savings income (which includes interest and offshore bond gains) of up to 5,000 can be taken tax free in addition to the personal allowance of 11,500. But the 5,000 allowance is reduced if earned income exceeds the personal allowance. So for example, if total pension income was greater than 16,500 the savings rate band would be lost. 2b. Personal savings allowance From April 2017 the first 1,000 of interest will be tax free ( 500 for higher rate taxpayers). Interest from banks and building societies will also be paid gross so that non-taxpayers no longer have to reclaim tax deducted at source. Additional rate taxpayers will not benefit from this new allowance. 3. Dividend taxation Since April 2016 dividend income has been paid gross without the 10% notional tax credit and a dividend allowance was introduced. The first 5,000 of dividend income will be tax free. For example, a 200,000 portfolio with a dividend yield of 2.5% would not be liable to any income tax. It means higher and additional rate taxpayers will pay no tax on their dividends within the 5,000 allowance. Dividends in excess of the allowance will be taxed at 7.5%, 32.5% or 38.1%. Basic rate taxpayers will now be subject to income tax at 7.5% on dividends over 5,000. From 6 April 2018, the dividend allowance will reduce to 2,000. Tax strategy Income up to the allowance should always be extracted. Typically, taxable income should be taken from the tax wrappers in the following order: Offshore bond gains Pension income (state, DB, DC) The savings rate band allows gains from offshore bonds to be extracted tax free. And unlike most other forms of savings income, the timing of gains from offshore bonds can be controlled to coincide with tax years when there is little or no other income. When combined with the personal allowance, it takes gains of up to 16,500 out each year. But this amount will be reduced where there is earned income such as fixed pension income (for example, state pension, DB pensions and annuities) which cannot be stopped once in payment. So where there are offshore bonds in the portfolio, deferring fixed pension incomes can create a window to extract offshore bond gains tax free. It is only the investment gain from the offshore bond which is taxable. But the withdrawal will also contain a return of the original capital which is not taxed, and can be used to meet spending needs or reinvested. For example, if an offshore bond has grown by 25% since investment (assuming no previous withdrawals have been taken) segments to the value of 50,000 could be surrendered of which the taxable gain would be 10,000. Income levels should be managed so that dividend income falls within the 5000 dividend allowance. The dividend allowance offers the opportunity to build up further large tax free savings in addition to their ISA, simply by using the allowances available. This can be achieved by keeping dividend income to below 5,000 pa, and realising capital gains annually from their portfolio with the annual CGT exemption ( 11,300 for 2017/18). The portfolio value at which no tax will be due of course depends on performance. But for example a portfolio with a dividend yield of 2.5% and capital growth of 5.5% would have no further tax to pay on its investment returns if capital gains are crystallised each year. Tax Policy Guidelines 5
Summary table (relates to UK taxpayers) Nil-rate Basic-rate Higher-rate Additional-rate Income Tax 0% < 11,500 0% < 11,500 20% > 11,500 0% < 11,500 * 20% > 11,500 40% > 45,000 20% < 33,500 40% > 33,500 45% > 150,000 Savings Rate Band 5,000 5,000 reducing to Nil ** Nil Nil Dividend Taxation 16/17 Nil 17/18 Nil 16/17 7.5% 17/18 7.5% 16/17 32.5% 17/18 32.5% 16/17 38.1% Dividend Allowance 5,000 5,000 5,000 5,000 Personal Savings 1,000 1,000 1,000 1,000 500 500 Nil Nil Allowance 17/18 38.1% * The personal allowance is reduced by 1 for every 2 of income over 100,000. Therefore, the personal allowance is lost once income exceeds 123,000 (2017/18). ** The savings rate band is reduced on a pound for pound basis when earned income exceeds the personal allowance. Therefore, no savings rate band is available if earned income exceeds 16,500. Capital Gains Tax - Annual exemption Your client s spending needs in retirement can also come from their personal portfolio holdings. Similar to offshore bonds, the withdrawal will be part gain and part return of original capital. It is only the gain element which is subject to CGT. The first 11,300 of capital gains can be taken each year tax free. Tax strategy Withdraw sufficient capital each year to use up but not exceed the annual CGT exemption. Any amount in excess of your client s income needs can be reinvested into: a. Pensions subject to available allowances b. ISAs subject to contribution limits 35,000 30,000 25,000 20,000 1,000 5,000 11,100 11,300 c. Back into personal portfolio to crystallise the gains and reset base costs (beware share matching rules and sale and repurchase within 30 days) Losses In years where the portfolio (or specific funds) has suffered a loss, these should be realised and repurchased through pension or ISA and losses should be carried forward to offset future capital gains. But where there are both gains and losses in the same tax year, the amount of loss to be carried forward must first reduce the gains in the tax year to zero. 15,000 10,000 5,000 0 5,000 5,000 10,600 11,500 Allowances 2015/16 Allowances 2017/18 Personal allowance Savings rate band CGT exemption Dividend allowance Personal savings allowance 6 Tax Policy Guidelines
Managing tax rates With over 33,800 in tax free allowances available in 2017/18 many clients will be able to enjoy tax free income in retirement by ensuring allowances aren t wasted. However, some clients will need more retirement income than can be provided within their available tax allowances, meaning that some tax will be payable. For example, this may be because fixed income already in payment (such as rental income, Defined Benefit or state pension) has used up both the personal allowance and savings rate band. These clients more complex tax affairs require a more bespoke tax planning service. Withdrawals from each of their investments will have its own separate rules on how gains are calculated and may be subject different taxes and tax rates. The key here for successful planning is to not just to pay less to tax today but to also to ensure actions you take now do not store up tax problems for the future. For example, income needs in excess of the allowances could be met from your client s ISA without creating any additional tax (and reducing their estate for IHT). Whilst this gives the most immediate tax efficient solution, it will only be sustainable until the ISA is depleted. If a similar income is likely to be needed for a longer period, your client may end up paying higher rate tax in the future on pension withdrawals (through having no other more tax efficient sources of income to draw on). Consideration could therefore be given to paying some tax now at basic rate, to avoid paying unnecessary higher rate tax later. The example on the following page helps to illustrate this point. The client s goals and circumstances will be critical to your approach, including: The level of income required over and above their available tax allowances The length of time it will be needed What impact IHT will have on their death Tax strategy 1. Income required > available allowances but < higher rate threshold The Centre for Policy Studies estimates that 6 out of 7 people who are higher rate taxpayers during their working life will never pay higher rate tax in retirement*. So, for most clients, income needs can be managed within available tax allowances or at most by paying some tax at basic rate. Where income required in retirement exceeds your client s available allowances but falls below the higher rate threshold, the optimal order of taking income tax efficiently could be: Personal Portfolio Offshore Bonds The annual CGT exemption is not affected by fixed regular income sources such as state pension or rental income. If the annual exemption has already been utilised elsewhere, withdrawals from the portfolio can be deferred until the following tax year. The use of multi-manager funds such as MyFolio can ensure that fund switches to rebalance portfolios doesn t use up the CGT exemption leaving it available to make tax efficient withdrawals to meet income needs. Gains in excess of the allowance are taxable 10% or 20%. This is half of the equivalent income tax rates. Any withdrawals will also reduce the estate for IHT. Surrendering offshore bond segments to provide the required income can limit any exposure to tax at higher rates both now and in the future. Withdrawals will benefit from top slicing relief and it may be possible to surrender just enough segments to keep the top sliced gain within the basic rate band. Remember that the full gain (before top slicing) is added to other income to determine eligibility for the personal allowance. If the combined amount exceeds 100k the personal allowance will begin to be withdrawn. Bond withdrawals will also reduce the estate for IHT. ISA The additional withdrawals required can be taken from the client s ISA (subject to any emergency fund requirements). There will be no tax payable on these withdrawals. The withdrawals will also reduce the estate for IHT. Pension Flexi-access drawdown can be taken from the pension to provide the additional income. This withdrawal will include 25% tax free cash. By using other sources of withdrawal before accessing the pension will preserve the amount pension fund which could be passed on tax efficiently. Remember that while it is now possible to take tax free cash after age 75 on the client s death undrawn tax free cash entitlement will become taxable when paid to the beneficiaries. It may be worth ensuring tax free cash is taken prior to age 75. * Source: http://www.cps.org.uk/blog/q/date/2015/04/07/time-for-tee-the-unification-of-pensions-and-isas Tax Policy Guidelines 7
2. Income required > available allowances and > higher rate threshold Where income needed in retirement exceeds your client s available allowances and is above the higher rate threshold. It could be more tax efficient over the longer term to first take income up to the basic rate threshold from the pension or offshore bonds, then take the balance from other savings. This is likely to preserve more wealth than solely exhausting other savings pots such as ISAs and Personal Portfolios (GIA) first. But this strategy is highly dependent on how long the income will be needed and how far into higher rate tax it falls. The personal circumstances of each client will determine the relevant strategy to adopt. Wealthier clients circumstances are likely to be more complex and will require a more bespoke service. For example, your client has a fixed income of 11,500 and wants a further 50k of income each year from their savings of 1m (split 250k ISA and 750k in their drawdown pension pot). 1. One option (option 1) would be to take the required 50k each year from their ISA to meet their income needs and only draw from their pension once the ISA funds are fully depleted. 2. An alternative (option 2) would be to take the required 50k each year as a mix of pension (up to the higher rate threshold) and the balance from their ISA. Maximise tax privileged wrappers Tax free investment returns Investments where income and growth are tax free within the fund will generally give a better return and consequently will improve income sustainability during retirement. Tax strategy Take withdrawals from savings which pay tax on their investment returns before tax free savings such as pensions and ISAs. Maximise tax privileged wrappers by moving savings from tax wrappers which have net returns to tax free returns where contribution limits allow. This helps to reduce any tax drag on future investment returns. 8 Tax Policy Guidelines
Inheritance Death benefits Clients who have saved enough to meet their income needs in retirement may be concerned about how to provide the best possible legacy for their loved ones. This may have a strong influence on how income is taken in retirement, especially if clients have an inheritance tax liability. The new pension death benefit rules for DC pensions mean that pension wealth is now far more inheritable, with reduced tax charges and greater freedom over who can inherit. Tax strategy Where inheritance tax is a concern, it is preferable to take withdrawals from assets which will form part of your client s estate over those that sit outside of their estate on death. Unlike most other investments, pensions are generally free of IHT and therefore withdrawals should be taken from other savings before pensions. On death before 75, pension death benefits can be paid to beneficiaries tax free. If the client dies aged 75 or over, beneficiaries will pay tax at their marginal rate(s) on any pension death benefit. Tax free cash Conventional wisdom is to exhaust tax free cash entitlement by age 75 (as it s lost on death after that age). However, where the client doesn t need the tax free cash and IHT is the primary concern, leaving it undrawn within the pension may give a higher inheritance. The beneficiary may pay less in income tax to access their inherited pension than would be paid in IHT outside the pension wrapper. And the funds could become tax free again if cascaded within the pension wrapper to future generations. Alternatively, the tax free cash could be reinvested into another tax wrapper, such as an offshore bond, and held in trust for the next generation. This would fall outside your client s estate after 7 years. The personal circumstances of each client will determine the relevant strategy to adopt. Wealthier clients circumstances are likely to be more complex and will require a more bespoke service. Tax Policy Guidelines 9
Appendix Understanding the tax system The order of taxation has a bearing on which income falls within allowances and the rates of tax payable on income or gains in excess of the allowance. Capital gains 4. Onshore bond gains 3. Dividends 2. Savings income (interest & offshore bond gains) 1. Earned income (including pension and rental income) 10 Tax Policy Guidelines
Income tax 1. Earned income. This will include pension income from all sources with state pension having first use of any personal allowance. Income above the allowance is then taxed at 20%, 40% or 45%. 2. Savings income. This will include deposit interest and interest distributions from fixed interest Personal Portfolios (GIAs). In addition it will also include any chargeable gains from offshore investment bonds. Income above the personal/savings rate band is taxed at 20%, 40% or 45%. 3. Dividends. This will include direct shareholdings and dividends distributions from equity Personal Portfolios (GIAs). The first 5,000 of dividend income will be tax free. Dividends in excess of 5,000 will be taxed at 7.5%, 32.5% or 38.1%. From 6 April 2018, the dividend allowance will reduce to 2,000. 4. Onshore bond gains. These are paid with a nonreclaimable 20% tax credit which will satisfy the liability for non-taxpayers and basic rate taxpayers. Gains in excess of the basic rate threshold will be taxed at 40% or 45%. Capital gains Capital gains will sit on top of all other income to determine the rate CGT is payable on gains in excess of the annual exemption. Taxable gains which fall within the basic rate tax band are subject to CGT at 10%; gains over the higher rate threshold will be taxed at 20%. Capital gains from the sale of buy to let properties will continue to be taxed at 18%/28%. Tax Policy Guidelines 11
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