I don’t know about you, but I’ve noticed we are now firmly into pre-budget speculation season.
There is nothing new in economic and political commentators looking to boost newspaper sales and website clicks by writing alarmist articles about impending budgets, but it feels to me that levels of speculation and anxiety are particularly acute this year.
We probably shouldn’t be surprised: we have a new Government and a new Chancellor, and we are not yet sure what they stand for. On the one hand, they say we need economic growth, and understand that lower taxes could help with this, but on the other, they tell us there is a black hole in the public finances and that some of us need to pay considerably more tax.
During the run-up to the election, Labour pledged not to raise tax on “working people” – specifically, not to increase the rates of income tax, national insurance or VAT. In theory, they could still change certain allowances or the scope of VAT – but relying on ‘clever’ interpretations of the manifesto pledge would be politically risky. Far more likely, as has been well-documented, is that Rachel Reeves’s sights will focus instead on other taxes such as Capital Gains Tax, Inheritance Tax and pension reliefs. With over a fortnight still to go until Budget Day on October 30th, journalists have free rein to continue to fan the flames of concern.
A recent article to cause potential worry was published by The Guardian and suggested that the Chancellor might choose to limit pension tax-free cash to just £100,000. In contrast, I’ve just read on the BBC’s news website that ‘Budget rule change could mean fewer tax rises’. Who should we believe? Journalists are not authorised and regulated by The FCA and they seem to be able to print what they like.
Of course, the change in pension rules could happen and the author of that article will have bragging rights. For someone with a £1M pension pot, the rules currently allow the first £250,000 (25%) withdrawn to be free of tax. This reduction, should it happen, could trigger an additional £30,000 in tax for a client paying tax on pension income at 20%, but it would be higher than this for higher or additional rate taxpayers and you would end up in these bands if you withdrew all £250,000 at once. Understandably, anything which threatens to undermine what for most people represents the foundation of their retirement and later life is a worry.
But the fact is that no one outside of the Government knows what is coming. So, what should a sensible person do?
In my view, we should not panic, but first remind ourselves that: –
- Journalists have always had a vested interest in fuelling speculation; playing on the fears of readers increases sales – it’s good for business. So, the proverbial pinch of salt is important.
- Rumours fly around every year before the budget and most guesses are wrong. If I had reacted to all journalist’s tips during my 34-year career, I am sure that I would now be considerably poorer for it.
Next, we should calmly consider what it would mean if this change to pensions does take place. We don’t want to pay additional income tax so we should do something quickly, right? Well, no, in most cases we shouldn’t. Why?
Because your pension is still likely to be more tax-efficient than the alternatives. What follows assumes all other current rules and taxes remain unchanged.
Saving Income Tax could lead you to pay Capital Gains Tax Instead
If you were to withdraw your tax-free cash, what do you do with it? You could, of course, invest your withdrawn tax-free cash in a portfolio with a similar tax treatment to your pension. “I could put it in an ISA and deliver the same returns, right?” Sadly, not quite. Whilst the tax treatment of your pension is similar to an ISA – there’s no higher rate of income tax or capital gains tax to pay on investment returns – remember, you can only invest £20,000 p.a. in an ISA. Investment gains on assets held outside an ISA or pension are subject to Capital Gains Tax and, you’ve guessed it, this tax could end up costing more than the additional income tax you might pay when you draw your pension benefits.
Keeping the funds on deposit will damage your wealth by more than a tax charge
You can try to outwit the Capital Taxes Department and leave the funds you have withdrawn in an interest-bearing cash deposit account. Then you would be cutting off your nose to spite your face. The dictionary helpfully describes this phrase as ‘a warning against needlessly self-destructive overreactions to a problem’. I often say that having the wrong investment asset allocation can potentially do much more harm to your wealth than tax and charges ever will. You would be giving up the higher expected returns of a well-structured investment portfolio by leaving your funds on deposit. A difference of just 2% p.a. in returns over 20 years is staggering. At a compound rate of 2% per annum (savings account) your reinvested pension withdrawal would grow 48.6% whereas an investment portfolio with a modest expectation of 4% p.a. it would increase by 119.1%. You could say to yourself, “but I don’t need this additional growth”. If that is the case, you shouldn’t be worrying about a small additional tax charge on your pension.
Your wider family could be worse off
The most likely reason why you should avoid needlessly withdrawing funds from your pension is to avoid unnecessary exposure to inheritance tax. Under current rules, your pension does not form part of your estate when you die. This means these funds can pass to your beneficiaries without a 40% deduction. Our clients know that by working with us on their lifetime cash flow they can be confident they will have more than enough wealth to meet all planned expenditure for the remainder of their lives. This means that any more money earned, or tax saved, will only end up impacting those who receive your estate when you are gone. The inheritance tax charged on your non-pension assets may well be far greater than any income tax saved today. In other words, unless someone is likely to be solely reliant on their pension to fund their later life and the proposed change to income tax represents the difference between having enough and not having enough, then the bigger picture is that there is no reason to panic.
My Final Thoughts
In truth, any and all tax rules could be changed by the Government. I can’t predict the amounts of taxes anyone will pay because other rules and taxes could change too. We simply do not know what changes Rachel Reeves has planned for Capital Gains Tax and Inheritance Tax, or for any other aspects of the fiscal landscape for that matter.
Managing tax liabilities is difficult at the best of times but, under the current levels of unprecedented uncertainty, trying to second guess the Chancellor is no better than a coin toss.
Attempting to jump from the frying pan will, at best, only see you landing in the saucepan and at worst, you could end up in the fire.
Before I finish it is worth noting that, whilst Herbert Scott is authorised and regulated by the FCA, they do not regulate tax advice. If you are concerned about tax, please don’t hesitate to get in touch. Over the years, we have built some great relationships with expert solicitors and accountants who can help with more complex scenarios.
Finally, do get in touch if you are concerned and, if you know someone else who is worrying about the budget, please feel free to share this post. We currently have capacity to take on some more clients and any referrals would be greatly appreciated.
Kevin
