The roles of pensions and lifetime mortgages in an all asset approach to financial planning

All financial planners (and many investors) are well aware of the powerful tax effectiveness of registered pensions. Tax efficiency is present throughout the “life of a pension”:  pension contributions receive income tax and NIC relief and are then invested free of UK taxes. NIC 'relief' is only available if it is paid into a Net Pay Arrangement (Occupational pension scheme or by way of a salary sacrifice agrement).  Personal contibutions paid into a Relief at Source scheme (personal pension scheme) are made after the deduction of income tax and NICs.  When the pension recipient dies, benefits usually attract no inheritance tax whenever they are paid and no UK income tax if death occurs before age 75 – so income tax is payable on death benefits only if the death occurs after that age.  Income tax is also paid if the benefits are not paid within 2 years of the death of the member.

Despite the undoubted tax attraction of registered pensions for these reasons, it’s worth keeping in mind that the chances of reaching age 75 are relatively high these days. Broadly speaking, over 8 out of 10 death benefit payments from pensioners’ plans will attract income tax, with a big chunk of the largest lump sums potentially falling into the additional rate.

Most scheme members have believed for many, many years that the main purpose of their pension is to provide income in retirement. However, this may be starting to change for some. At first it may seem somewhat counter-intuitive, but from an estate planning viewpoint it can be better to run down personally owned investments while leaving their pension-wrapped counterparts untouched. That way the IHT-liable assets are reduced while the potential IHT-free assets continue to enjoy the favourable pension tax environment. The solution works for those with substantial non-pension investments, but they are the minority – most people have to rely on their pensions for income. Or do they?

Aside from the potential IHT benefits, a lifetime mortgage can provide a series of regular loans to be spent as untaxed amounts – effectively income replacement. The loans can replace all pension income or become part of a “mix and match” strategy, with pension drawdown topping up the loan when needed.

As a result:

  • If a loan replaces taxable income, the grossed-up equivalent of the amount of that loan remains in the pension. For example, for a basic rate taxpayer, £800 of loan is equivalent to a gross pension withdrawal of £1,000. What stays in the pension is outside the IHT net and remains in a tax favoured environment.
  • The loan is a mortgage debt against the estate. It will reduce the potential IHT payable on the estate as it reduces the taxable value of the estate, after allowing for available nil rate band(s).
  • Any other assets are unaffected by the arrangement, so can continue to provide income or, possibly, be used for lifetime gifting.
  • The potential for replacing pension drawdown with lifetime mortgage drawdown needs careful analysis for a range of often interrelated reasons. Just consider the following :
  • The higher the marginal income tax rate of the pension owner, the more attractive the mortgage option because of the greater amount it leaves in the pension. For example, a basic rate taxpayer needing £10,000 of net income would have to draw £12,500 gross from their pension. The corresponding figure for a higher rate taxpayer is £16,667.
  • The indexation of the nil rate band (NRB) and the residence nil rate band (RNRB) from April 2021 (which will have also applied to the RNRB taper threshold, currently £2,000,000) did not proceed and instead we are living with a continuing freeze until 5th April 2026. It’s worth remembering that the threshold is calculated as the value of the estate after liabilities (eg a lifetime mortgage), but before taking into account any exemptions or reliefs (eg business or agricultural relief).
  • Of course over time, a gradually drawn lifetime mortgage will likely offset the value of the equity in a property. When a shrinkage in equity means that the available residence nil rate band(s) cannot be fully used, the debt becomes counter-productive. There are three factors at work here: property price growth, CPI inflation (fixed and thus known) and mortgage interest rate. The same issue arises if the value of the net estate falls below the available NRB(s) and RNRB(s).
  • As the combined NRB and RNRBs are now £1m for a married couple or civil partners, this generally pushes the drawdown lifetime mortgages/pension combination into high wealth territory. However, lower thresholds will apply to single people (including divorcees) and those, such a childless couple, who have no beneficiaries that would allow for a claim for the RNRB.
  • On death prior to age 75 there will be a lifetime allowance test before death benefits are paid. It is only lump sum payments in excess of the lifetime allowance that will trigger an income tax charge on the recipient. 

The greater the effective rate of income tax that is payable on the pension death benefit, the less the advantage of potentially sidestepping IHT. Six figure lump sum payments to individual beneficiaries are going to attract marginal rates of 40% or 45%, never mind personal allowance taper. From a tax planning viewpoint, opting for dependant’s/nominee’s drawdown will often be preferable to taking a one-off lump sum.

The existence of so many “moving parts” means it’s very difficult to generalise when the lifetime mortgage route potentially produces better results than straightforward drawdown. Clearly, some combinations will be non-starters, such as where the mortgage will rapidly mean the loss of the use of the full RNRB, or if a move to residential care is imminent.

What a consideration of the lifetime mortgage alternative to pensions does show is that in a world of low interest rates, old ideas about the role of equity release need to be revisited. This is especially so in relation to the role of a pension within an overall “all asset” approach to financial planning. The factors to take into account and the choices that have to be made to deliver optimum outcomes are relatively complex. The role of informed financial advice in such an “all asset” approach to financial planning is self- evident.

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