How to outsmart the annual and lifetime pension allowances
The amount of money that can be saved in a pension over a person's lifetime was reduced to £1 million in the 2016/17 tax year, down from £1.25 million the year before, as the government sought to curb tax breaks for wealthy savers.
It's an expensive business to breach the lifetime allowance: a tax charge of 55 per cent is due on money above the limit if it is taken as a lump sum, or 25 per cent if it's taken as income.
This threshold encompasses not only pension contributions but also any growth and dividends earned in a pension fund.
Thus, although the limit may seem generous, a growing number of middle-income pension investors are in danger of breaching their lifetime allowances - in some cases even if they make no further contributions to their pension pots. In effect, the lowered lifetime allowance is set up to penalise successful investors.
HIT FOR HIGH EARNERS
This restriction has been compounded by the tapering of the annual allowance for those earning more than £150,000 a year.
Although the annual pension contribution allowance is currently £40,000 - more than enough for most people - since April 2017 it has been reduced by £1 for every £2 of income earned over £150,000, until it reduces to £10,000 for those earning £210,000 a year or more.
The cutting of pension allowances has left savers with sizeable or rapidly growing pension pots with fewer options for retirement investment, and more are turning to higher-risk alternative tax-efficient investments, such as enterprise investment schemes (EIS) and venture capital trusts (VCTs).
Andrew Aldridge at EIS provider Deepbridge says alternative investments are 'not just for the wealthy anymore'. He adds: 'Teachers, doctors and middle managers are all reaching the [lifetime] pension limit now, not just the super-wealthy.'
Investors can invest up to £200,000 a year in VCTs and £1 million in EIS in any tax year. One main attraction of VCT and EIS investments is the tax reliefs on offer: both offer 30 per cent income tax relief on the purchase of new shares (but not resales).
Any gain made on investments is exempt from capital gains tax (CGT). EIS investments have to be held for three years and VCT investments for five to qualify for the key tax reliefs.
Jason Hollands, managing director at adviser Tilney Bestinvest, says he has seen pension changes correspond with increased interest in alternative investments.
Although the reliefs are similar for both EIS and VCTs, Hollands says the investments offer individuals very different options for generating growth and income.
'People assume EIS and VCTs are capital growth investments,' he says. 'VCTs are actually more about investing for income, but EIS are not. VCTs pay tax-free dividends and EIS do not.
'EIS are about making a capital return when the company [invested in] is sold, but VCTs distribute the profits made in the portfolio as tax-free dividends.'
Hollands adds that in a low-yield environment, VCT yields are seen as 'attractive', as 'double-digit [yields] are not uncommon'. This income is particularly beneficial for those who are using VCT investments as they go into retirement.
'VCTs should be seen as a way of generating income, and they are attractive for a retirement portfolio,' he advises. 'Often people take the option of reinvesting the dividends [distributed by the VCT] while they are working, but then take the tax-free dividends [as income] in retirement.'
DIVERSIFY AND DON'T GO OVERBOARD
Simon Ruthers, business development director at EIS provider Oxford Capital, says pension allowance cuts mean investors have to 'look at diversification, not just at investment level but at wrapper level'.
He suggests investors look to fund their pensions and Isas up to their limits and then look at other investments - and expect to fund retirement from a variety of pots.
'To fund retirement, you can take money from your pension, dividends from a stocks and shares Isa, maybe dividends from a VCT or a tax-free return from an EIS,' he says.
'You may be receiving a significant amount of money but paying little or no tax. It is about prudent planning and making sure you can manage your wealth in ways that use your allowances, whether they be income, capital gain or dividend allowances.'
Ruthers maintains, however, that 'pensions have to be the cornerstone of retirement planning'. Hollands also encourages savers who have maxed out their pensions to use their Isa allowances - which will increase to £20,000 from April - before they look at alternative investments.
Individuals should also ensure VCTs and EIS only make up a 'modest part of their portfolio', as early-stage companies are high risk. '[Alternative investments] are not a replacement for pensions because they are higher risk, but they are definitely part of the armoury,' says Hollands.
'The important thing is not to go overboard. The investments are focused on very small companies, and they are illiquid [investments].'
Not only are investors unable to sell shares in EIS schemes for at least three years and in VCTs for at least five years without losing the 30 per cent tax relief, but there is also no secondary market for EIS shares.
That means investors must wait until the EIS exits a company - usually through a sale - before their gains are realised, which often takes more than three years. Hollands adds: 'VCTs, in contrast, have a secondary market and buyback processes, but you cannot sell for five years.'
Ruthers says investors need to ensure they are comfortable with the potential for loss that comes with investing in early stage companies.
'You need to carefully balance out the potential reward and risk, consider the likelihood of a loss and think about duration, as these investments are lliquid.
'Alternative investments such as these should be a smaller part of your overall pool of wealth,' he says. 'You have to accept higher risk and remember that losses are not uncommon.'
DEARTH OF OFFERS AVAILABLE
It is not just the high risk associated with these investments that investors need to watch out for. Hollands says that when it comes to VCTs, there is a 'dearth of offers available'.
There have been several changes to the types of businesses VCTs and EIS are allowed to invest in.
This has made it more difficult for alternative investment managers to find suitable firms, and many were cautious about putting money into new companies while the government was still finalising the new rules.
'A number of VCTs have raised quite large sums of money and have a lot of cash. But many have stopped doing deals,' says Hollands.
'There are 14 or 15 VCTs open, but the level of cash being sought is lower. If investors wait until the end of the tax year to invest, as many will, they may find all the better schemes have been filled.'
Despite the risks, there are advantages to investing in both EIS and VCTs, mostly around tax planning. EIS investments can help those concerned about exceeding the £325,000 inheritance tax (IHT) limit and incurring the 40 per cent IHT charge.
Shares held in an EIS typically qualify for 'business property relief', which means that after two years the shares held fall outside the investor's estate for IHT purposes.
Alternative investments can also help investors who have a large CGT bill - after selling a business or rental property, for example.
That's because if gains are invested into EIS qualifying shares, any CGT due is deferred. The process can be repeated as the EIS matures and gains are reinvested, each time benefiting from 30 per cent tax relief.
Aldridge says investors should look at alternative investments from a tax planning perspective initially, but they must keep in mind that they are putting their money at risk.
'Investing in EIS and VCTs is always high-risk, and you should seek financial advice if you're investing as part of a wider tax plan,' he advises.
PENSION POT PROTECTION IS AT HAND
The pension contribution lifetime allowance has been reduced dramatically since it was introduced in 2006: it has shrunk from £1.8 million in 2010 to £1 million today.
The constant chipping away means protections have been put in place by the government for those who reached the lifetime allowance on specific dates, to ensure they are not unfairly subject to a tax charge.
Investors have to apply for pension protection. The version they need will depend on the level of their pension on a certain date.
- Individual protection 14: Savers must have had benefits of more than £1.25 million on 5 April 2014 to apply for this protection for a pension fund of £1.25-£1.5 million. The application deadline for protection is 5 April 2017.
- Fixed protection 16: Savers must have stopped contributions before 6 April 2016 to qualify for this protection for a pension fund of up to £1.25 million. There is no minimum pension pot size required.
- Individual protection 16: Savers must have had benefits of more than £1 million on 5 April 2016 to apply for this protection for pension funds of £1-£1.25 million.
Claire Trott, head of pensions strategy at financial planner Technical Connections, says savers applying for fixed protection 16 will have to stop contributing to their pensions 'or they will lose the protection, while those applying for individual protection 'get a personalised lifetime allowance of whatever they have at the applicable date', capped at the upper limit.
Applying for pension protection is free. Applications should be made through the government website.