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Buy-to-regret?

10 April 2015

Retirees tempted to invest their pension pot in property should think carefully.

It may have seemed a long time coming, but for the millions of over-55s waiting for the new pension reforms, the retirement revolution finally got underway this week.

People over the age of 55 with a defined contribution pension now have the freedom to keep their fund invested and draw from it as they see fit, without restriction on the amount that can be taken in a single year. In one fell swoop, the government has empowered a generation of retirees to do much more than they could before; and for a few individuals the new rules, or specifically the removal of the old ones, will be the key that opens the door to a number of possibilities – including the idea of investing in the buy-to-let property market.

Whilst it will do nothing to ease the pressure on housing stock, a potential new wave of amateur landlords is not surprising when you consider the meagre returns on cash savings over the past few years. Not only does buy-to-let offer the potential for attractive levels of rental income and capital gains, but retirees may feel they can tread a more familiar path by investing in bricks and mortar. Television programmes that suggest anyone with a bit of spare cash can be a successful property investor do nothing to dissuade them from giving it a go.

According to a recent study, gross rental yields in some property hotspots can be as high as seven or eight per cent per year.1 As impressive as this sounds, buy-to-let is not necessarily the fail-safe investment opportunity these figures suggest; there are many other factors that need to be taken into consideration.

Tax tail

What remains certain in life, and death, is taxation. This, along with some other pitfalls, could cause some unexpected consequences for the unwary; so individuals looking to cash in their pension to purchase property will do well to consider these before jumping in with both feet.

As residential property cannot be held in a pension, people purchasing a house or flat will firstly need to draw the required sum from the fund. The new rules make it possible to withdraw the whole fund, with 25% of it available tax-free but with further amounts taxed at the individual’s marginal rate of Income Tax. People taking a large withdrawal could therefore find much of it, along with any other income for that year, taxed at the higher 40% rate, or the top rate of 45%.

The simple illustration below demonstrates the potential tax costs of withdrawing the entire pension in a single year, the rental income that could be achieved from the net proceeds invested in a buy-to-let property, and the yield needed to achieve the same level of income if the whole fund remained invested in a pension.

Assumptions: The above is based on 2015/16 tax rates. The individual withdraws their entire pension savings and receives 25% tax-free cash. The individual has no other taxable income in the year they withdraw pension savings. No other costs or tax charges, such as tax on yields, are factored into the calculations.

Unfortunately, the potential tax burden doesn’t end there. If the value of the buy-to-let property rises sufficiently, it will be liable for Capital Gains Tax when it is sold. In addition, any property owned by the individual forms part of their estate for Inheritance Tax (IHT) purposes. Then there’s the business of appointing a letting agent, paying for repairs, working with tenants – all things people may not want to have to deal with as they get older. And for those who can’t afford to buy the property outright, a buy-to-let mortgage will have to be secured.

In contrast, wealth held in a pension fund is remarkably tax-efficient for those who choose to keep it there. Investments are not liable to Capital Gains Tax while they are in a pension, regardless of how much they grow; and if an income is required from the pension, you can take flexible payments through the newly created ‘flexi-access drawdown’ facility. This allows income to be drawn at a rate that suits you, or that you determine to be the most tax-efficient.

Passing property

Whereas property counts towards the value of your estate for IHT purposes, pensions do not. A pension can even be passed on to beneficiaries tax-free if you die before age 75. If death is later than this, income from the inherited pension is taxed at no higher than your beneficiary’s marginal rate of Income Tax.

There’s no doubt that buy-to-let can offer some attractive upsides, but investors who have saved diligently into a pension because of the tax breaks will baulk at the prospect of handing back 40% or more in tax. Those who understand the need to maintain their standard of living throughout retirement will be working hard to minimise the tax they have to pay and making sure they seek financial advice before making any decisions.

The information contained within this article does not constitute investment advice. It is not intended to state, indicate or imply that current or past results are indicative of future results or expectations. Full advice should be taken to evaluate the risks, consequences and suitability of any prospective fund or investment.

The value of an investment with St. James’s Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up. You may get back less than you invested.

1 HSBC, 27 May 2014

The levels and bases of taxation and reliefs from taxation can change at any time. The value of any tax relief depends on individual circumstances.

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