Maximising the Effectiveness of Pension Planning

Now that A Day is here many clients are focussing on pension planning, especially dentists who are leaving the NHS or are planning to. This week we look at how to structure your pension planning for maximum benefit.

Situation

Let's presume for a moment that a pension plan is the best option for a client's planning. This dentist, lets call him Ben, is looking to semi retire in his 50's and fully retire by 60.  Now in his early 30's, Ben asked us about added years and personal pensions. He likes the sound of 40% tax
relief, as does his accountant.

So it appears to be a simple decision, especially with the tax relief.

But Ben's decision will be influenced by whether he will be continuing NHS work, as he will continue to build pension benefits in the scheme.

If Ben invests, say, £5,000 per annum he will receive £2,000 of this in tax relief. This could then buy him a pension for life when he is 55 to 60, as well as being able to receive 25% of the fund in tax free cash.

Other considerations

However, should the pension investment be for Ben or his wife, Fiona?

Ben has recently married, to Fiona, who is 8 years younger than he is. Fiona is a part time nursery nurse with no pension of her own. As well as this, Ben and Fiona plan to start a family, which means that Fiona will be stopping work indefinitely. She will, however, be employed by Ben as a part time PA, working a few hours per week.

Fiona will have fewer pension benefits overall than Ben who already has substantial NHS benefits and he will be probably be a 40% tax payer in retirement, on the NHS Pension income alone.

Let's also look at a different calculation. Many clients we speak to concentrate on the tax relief now as the reason to act, possibly on the advice of their accountant. As planners we also look at the situation now, but equally the whole point of a pension is to give the required standard of living in retirement, and to be tax efficient then as well.

So if we look at this, the sums show an interesting story…

When Ben takes his pension, he will be a 40% tax payer in retirement, while Fiona will be a non-tax payer. Therefore a £400 per month pension for Ben is actually £240 net, whereas Fiona would receive the full £400.

After age 65, on a £600 per month pension (before tax), Ben would receive £360, and Fiona £600. This is because personal allowances rise with age.

If we also remember that it is very likely that Fiona will outlive Ben by some 6 or 10 years, the sums look even more favourable. On Ben's death, his pension will either cease or pay (typically) 50% to Fiona. But if the pension is on Fiona's life it will continue until her death.

Example A – based on Ben

So, lets look at the £400 per month example. Ben retires at age 55, and dies age 82, and we presume Fiona survives Ben by 8 years on a 50% for spouse basis (with the pension being taxed at 22% on Ben's death), with Fiona dying age 90.

Total net income received - £107,000.

Example B – based on Fiona

As above, with the presumption that Fiona accesses her pension at age 55. This means that the fund not accessed at age 55 for Ben has now grown at 7% per annum resulting in Fiona receiving a £480 per month pension.

Total net income received - £201,000.

We must of course build in the fact that they would have received income for 8 years if Ben had indeed taken his benefits at age 55, which would have resulted in payments of circa £23,000.

Taking all this into account , the difference is £70,000!

PLEASE NOTE: The actual income received will depend upon pension fund growth, inflation and annuity rates at the time of purchase.

There are many other factors to consider:

- The tax relief available to Ben will be at 40%, while for Fiona it will only be 40% if the employer/employee relationship is established. If not, tax relief will be at 22%.

- We have excluded any entitlement to State Pensions. If this was payable to Fiona it would alter the amount saved by the amount of tax payable on this pension.

- If the pension were based on Ben, the new pension rules giving limits on benefits may be breached, resulting in a tax penalty.

The Key Considerations

Before you invest into a pension plan (of any type) you need to consider how the benefits will be taxed when the income is paid out, NOT JUST HOW MUCH TAX RELIEF YOU RECEIVE NOW.

Work out your income objective and work back from there. You'll then be in a position to decide how to structure any pension planning, and maximise the potential income.