New pension rules that began on 6 April mean that a non-taxpayer aged 55 to 70 with £10,000 savings in the bank can turn it into more than £15,000 over five years at no risk.
The arithmetic is mind-bending. But the principle is simple enough. Anyone aged under 75 can contribute up to £2808 a year into a pension each tax year. And even if they do not pay tax the kindly old Chancellor (yes Gordon Brown) will stump up another £792 from the Treasury’s coffers to make the total going into the pension a respectable £3600 every year.
Rule two – which is the new one – allows people aged at least 60 (and under 75) to cash in their pension funds as long as the total value of all their pensions (apart from the state pension) comes to £15,000 or less. They must cash in all those pensions within a twelve month period.
When you combine these two rules you realise that non-taxpayers who have no pension or other income but some savings in the bank can move their money into a pension year by year until it grows to £15,000. And then take it out. Each time they move £2808 the Chancellor tops it up by £792 – a bonus of more than 28%.
Not everyone can do this trick. First you must have no other pension. That means no pension from your job – even one you haven’t yet started to draw – no pension inherited from a late spouse, and no other personal pension. The second thing – and this makes it better but is not essential – is that you are a non-taxpayer. Ideally you should have no income at all. Not even the state pension. If you do, you can still do the trick but the Chancellor will take some of it back as tax. Remember that even if you are entitled to a state pension you can defer drawing it and keep your income to zero. If you have no income you can time things so that the tax you pay is negligible. Around £30 out of the more than £5200 you have made.
Here is the step by step guide.
Let’s assume you are 56 on June 1st this year. And that you have no income and £10,000 in the bank which you don’t need to live on. I am presuming that you have a beloved who keeps you. And indeed when he or she sees how this great scheme works they might even give you the £10,000 to start it off!
Year one. You’re a canny investor so you put your £10,000 somewhere sensible where it earns 4.5%. You can get a bit more than that but we want total flexibility to take money out when we want so 4.5% is a reasonable target. You tell the bank that you are a non-taxpayer so it pays the interest into your account gross without taking off 20% tax first. On June 1st you use £2808 of your savings to start a pension. We will call this Pension A because you are going to start two separate pensions for reasons that will be explained later.
As this is a short term scheme you do not want to take any risk with your money on the stock market. So choose a stakeholder pension with a cash unit trust option and put your money into that. At the moment you can get 4% to 4.4% a year on those and the return is guaranteed. Unfortunately so are the charges and they will be up to 1% a year. So the net gain on the money you invest, depending which you choose and what happens over the next five years, will be at least 3% a year.
At the end of Year 1, on 31 May 2007, your savings are a shade over £7500 and there is about £3700 in your pension pot. You have already made £1200 because the Chancellor has added £792 tax relief and your savings have earned 4.5% and your pension 3% net. The next day you start another pension, B, with £2808 from your savings generating another £792 from Gordon (or whoever is Chancellor then!). Again, you choose a nice safe cash stakeholder and let’s assume it grows at the same rate of 3% after charges.
A year later your remaining savings are worth just over £4900 and your two pension funds have grown to more than £7500. On 1 June 2008 you put more money into pension A. You bung in £2808 from your savings. And the Chancellor…etc.
Another year and it is June 2009. Most of your savings have been moved into the pension but you still have about £2200 left. Your two pension funds have grown to more than £11,400. You use all your remaining savings to add to Pension B and you get tax relief added of more than £600. Time passes and the money grows.
On 1 June 2010 you reach the age of 60. At that age you can cash in your pensions as long as they are less than a certain amount. This year that total amount is £15,000 but by June 2010 the limit will have grown to £18,000. Your total funds in pension A and B are far less than that at around £14,700. You could just cash them both in but by cashing them in separately you reduce the tax that is due to almost nothing.
The way it works is this. The first quarter of the fund is tax-free. The rest is added to your income and taxed. As you have no other income you can have up to £5,035 in the tax year without paying any tax. Pension A is a shade under £8000 but remember a quarter is tax free so that leaves almost £6000 to be taxed as income. But this is June 2010 and by then the personal tax allowance will have risen with inflation and should be around £5560. So you will only be taxed on a small amount of the lump sum and because it is so little the tax rate will only be 10%. The tax due will be about £35. Take that off and you have a nice lump sum of more than £7800 to put back into your savings account.
You leave Pension B where it is for now. You have to cash it in within twelve months of cashing in Pension A. So you wait until the next tax year begins on 6 April 2011. That means you have a fresh personal tax allowance to use. So sometime in May you cash in Pension B. It is worth a bit less than Pension A was at a shade over £7000. Three quarters of that (remember you can take a quarter of it tax free) is about £5300 which is less than your allowance. So all the lump sum is tax-free. You bung that back in your savings account. The lump-sum from Pension A has been there a year and has grown to almost £8200. So with your new lump sum from Pension B you have a grand total of more than £15,200 in there. In five years you have gained more than £5200 after tax. Most of that has come from the tax subsidy paid into pensions by the Treasury and the money that has earned from being invested.
If you pay tax you can still make use of these rules, but the gain will be less because three quarters of the lump sum will be taxed. Even so, you can reckon on making about £1200 more over the five years than you would get keeping the money in the savings account.
22 April 2006