Today’s post is about efficiently getting your money out of a SIPP once you reach retirement – we’ll look at the impact of the LTA on SIPP run-off.
Although I’m sure everyone is familiar, here are the basics of how SIPPs operate:
- You can put in up to £40K a year
- This limit used to as high as £255K
- You get income tax relief at your marginal rate on these contributions
- At age 55 you can access your pot
- This age is planned to increase to remain 10 years behind the State Pension Age (SPA), but no legislation has been passed to make this happen.
- You can take 25% of the pot as a tax-free lump sum
- This only makes sense if you have something to spend it on – otherwise you’re just moving money from a tax-sheltered place to a taxable one
- You can move the rest into drawdown
- This is just a version of the SIPP that pays you an income
- The income is taxed at your marginal rate like other income
- Your third option is to take occasional (probably annual) lump sums from your pot
- This is called UFPLS, and the first 25% of the lump sum comes from your 25% tax-free allocation
The other limit on pension behaviour is the LifeTime Allowance (which we’ve written about here).
This caps the amount that you can take out of your pension before a punitive tax charge is made.
- The limit is currently £1M, though it has previously been as high as £1.8M
- In April 2018 the LTA will rise to £1.03M, as it is now index-linked.
£1M sounds a lot, but it translates to index-linked annuity income of £25K pa at age 55.
- Some people will have protected their LTAs at £1.8M, £1.5M or £1.25M, as the limit was reduced.
This charge is 55% on lump sums and 25% on income (on top of regular income tax).
- That’s enough to cancel out the advantage of receiving income tax relief in the first place.
Withdrawals from your pot and transfers into drawdown are assessed against your LTA and a percentage chunk is removed from it.
- Then at age 75 your remaining pot is assessed against your remaining allowance.
This happens even if you have moved it into drawdown, so you can’t escape the eventual tax charge by converting you pot into income-producing.
So today’s problem is the biblical challenge of getting a camel through the eye of a needle:
- We have a maximum of 20 years to take as much money out of a SIPP as possible, whilst incurring the minimum tax.
To make things as difficult as possible, we’ll assume that the SIPP is full (contains £1M at age 55).
Since the LTA is now index-linked, we can ignore inflation in our calculations.
- My spreadsheet includes inflation because it was built to test my own SIPP.
I have LTA protection at £1.25M, and this is not index-linked.
- So in around 10 years, the prevailing LTA will be higher than my protected LTA, and I will have to abandon my protection.
For today’s purposes, I’ll use an adapted version of my spreadsheet, and set inflation to 0% pa.
The original sheet assumed that tax bands increase with inflation (and ignores radical changes – under a Labour government for example).
- With inflation set to zero, this has no impact.
Some readers may be wondering what the problem is.
- We have a SIPP with £1M in.
- We’re allowed to take out £1M without abnormal penalty.
The missing factor is investment growth.
- If our investments grow at all over the 20 years from 55 to 75, I fear we are doomed to pay a penalty tax.
So in reality we will be comparing scenarios as a form of damage limitation.
I will begin with a conservative growth rate of 2% pa (after inflation).
- Depending on the results, I might look at 4% pa as well.
To look at this problem properly, we should discount back the future cash flows to see what their value is in the present day.
- But today’s post is just a top-level look at the problems of decumulation, which aren’t discussed as much as those of accumulation.
We aren’t comparing two closely matched investment opportunities, we’re just comparing basic strategies for getting money out of a tax-sheltered pot.
As we saw recently when we looked at the Stanford study of retirement strategies, the optimal strategy contains three elements:
- a guaranteed base level (from the State Pension and DB pensions)
- a cash buffer of four to five years of living expenses, so that you don’t need to sell stocks during a market downturn.
- a gradually accelerating withdrawal from a mostly-equities pot
Today we are only mainly at item 3, with a brief consideration of item 2 in the closing section.
- Item 1 is included to the extent that a State Pension at Age 67 is included in the spreadsheet calculations.
Straight line LTA
The simplest drawdown approach is to withdraw the same amount every year (with a kink down when the State Pension becomes due).
- The annual withdrawal is chosen so as to fill the LTA over 20 years.
At first glance, with a million pound pot and 20 years to spend it, £50K looks like the correct starting amount.
- But that’s aiming at pot exhaustion, not LTA exhaustion.
It turns out that £54K is the correct starting amount.
The key numbers to look for are:
- £1.034M withdrawn (100.7% of the LTA)
- £226K left in the pension pot at age 75 (after that year’s withdrawal)
- £0K of income in the higher rate tax band
- LTA tax charge of £69K (I’ve assumed the 25% additional rate for income)
At the other extreme, we could try to run the pot down entirely by age 75.
- This involves a somewhat higher annual withdrawal of £63K to begin with.
The key numbers here are:
- £1.222M withdrawn (119% of the LTA)
- An empty pot at age 75
- £19K of income in the higher rate tax band (attracting an additional tax charge of £29.4K)
- LTA tax charge of £59K
A third approach is that recommended in the Stanford study:
- To take the gradually increasing government mandated RMDs (required minimum distributions).
These are designed to maximise tax revenue for the government.
- But since they do so by exhausting your pension pot as you reach your life expectancy (rather than at age 75) they can be useful to any retiree.
RMDs don’t exist for the UK, and we have four problems in constructing them:
- They change every year to reflect actuarial calculations of life expectancy.
- The Stanford report has only the numbers for ages 70 to 90 (for 2017), and we need to start at age 55.
- I have a table that goes from 70 to 115, but it’s from a different year.
- And since it doesn’t extend below age 70, it’s not really an advance on the Stanford data
- UK and US life expectancies are different.
But as they say, perfect is the enemy of good, so we’ll have a go anyway.
- I used the Google Sheets TREND() function to extrapolate the Stanford data for ages 70 to 75 back down to age 55.
- I worked out the difference between US and UK life expectancies (0.6 years, in favour of the UK)
- I added this to the US distribution periods to work out the slightly lower annual payout rates for the UK.
The payout rate starts at 2.41% at age 55 and rises to 4.26% at age 75.
RMDs to age 75
We can see immediately that these payout numbers are too low.
- Even the straight line LTA approach starts with withdrawals of 5.4% (£54K)
This is not surprising, since the US government’s target is to exhaust your pension pot just before you die.
The table we just produced is useful in that it shows a safe withdrawal rate for your entire portfolio, but it’s not what we need today.
- Instead, we need the same table, but with the distribution period constantly adjusted to end at age 75.
Here’s the run-off table for those payout ratios.
The key numbers are:
- £1.242M withdrawn (121% of the LTA)
- An empty pot at age 75
- £120K of income in the higher rate tax band (attracting an additional tax charge of £24K)
- LTA tax charge of £52K
Comparison of three approaches
Here’s a table summarising what happens under the three approaches:
The disappointing news is that these three approaches produce quite similar outcomes over 20 years of withdrawals.
- My interpretation of this is that we have looked at three reasonably good approaches, and ignored all of the terrible ones.
- I also think that a modest investment growth rate of 2% pa is likely to have flattened out the results somewhat.
The main potential source of differentials is the LTA levy, which can’t be offset (unlike income tax, which can be offset using VCTs and / or EIS).
- The key takeaway is that you need to use up your LTA by age 75, before the charge is levied.
The LTA charge is similar for all three approaches, and the running cash balance at age 75 (net of the LTA charge) is within 3% for all three options.
- The main choice is whether you want to exhaust the pension pot at age 75 (RMDs, pot exhaustion) or retain some money (straight line LTA).
After deducting income tax, the straight line LTA appears to be best.
- But if you were to offset all of your income tax (via VCTs and EISs) then the three approaches produce similar results once more.
My plan is to start off with the straight line LTA approach, since this provides the most flexibility to change direction in the future.
- I can then run these calculations once a year – using real-world data – to work out if any change is required.
There is one other way of limiting the damage from the LTA penalty charge.
- You could vary your asset allocation between SIPPs and other investments (say, ISAs).
I am likely to always keep between 5% and 10% of my net worth in cash.
- There’s no reason why I shouldn’t keep nearly all of that in my SIPP, where it would attract no interest.
That would lower the overall growth rate in my SIPP, leading to a lower tax charge at 75.
- Note that I would also need to increase my exposure to risky assets outside of my SIPP to maintain my correct asset allocation.
Otherwise my lower tax bill will be accompanied by lower expected portfolio returns.
More adventurous investors could even look at including loss making assets in the SIPP, coupled with the reverse assets in an ISA.
- For example, you could hold inverse FTSE index trackers (perhaps geared ones) and offset them with spread bets, options or plain positive index trackers.
For now, I’ll restrict myself to putting more cash into the SIPP.
Until next time.
Article credit to: https://the7circles.uk/retirement-strategies-2-sipp-run-off-and-the-lta/