21st November 2014

Buy to let vs Drawdown

Matt’s 61, he’s married to Liz who’s 58 and they have two adult children. Matt enjoys his consultancy work and while he’s reducing his hours, has no plans to fully retire before he’s 70. He has a personal pension fund valued at £250,000. He used an inheritance to buy a new build property for £165,000 early in 2013. He’s renting it out at £695 a month, but would charge more to new tenants. He expects to receive net rental income of £7,500 a year, based on his experience so far of expenses and void periods.

He’s suspicious of pensions and influenced by the ‘no-one needs to buy an annuity any more’ headlines. He confirmed his prejudices by checking an online calculator and concluding he’d need an annuity with 3% escalation and a 50% widow’s pension. On this basis, if Matt took 25% tax free cash of £62,500, the £187,500 balance of his pension fund would secure what he considers a disappointing initial income of £6,420 a year. His adviser agrees that an annuity isn’t right for someone in Matt’s position. He doesn’t need to secure a lifetime income, both he and Liz are relatively young, in good health and don’t smoke - and their exclusive postcode is another disadvantage when it comes to annuity purchase.

While his adviser is keen to turn the discussion to drawdown, Matt’s instinct is still to use the 2015 rules to unlock his pension cash to purchase a second buy to let property to provide additional income both now and when he ceases paid work. He believes he’d be able to buy a similar property for £180,000 plus legal expenses and stamp duty and rent it out for £795 a month. Based on his experience so far, he expects to get a net rental income of £8,590 a year but accepts it could be less than this. He sees significant advantages compared with an annuity. He’d not only get a higher increasing income, but also the possibility of capital growth. If he predeceased Liz, she would inherit the property free of inheritance tax, along with the full income stream. His children could also inherit.

Matt explains his thinking on how he’ll finance the purchase. He plans to limit his consultancy earnings for 2015/2016 to £30,000, and expects to get £7,500 net rental income from the existing buy to let and about £4,300 net over six months from the new property. His understanding is that provided he ensures his other income is within the basic rate band, he’ll be entitled to 25% tax free cash of £62,500 and will pay 20% tax on the £187,500 taxable portion of his lump sum leaving him with £212,500.

His adviser explains that using his assumptions, he’d actually end up with around £166,932 after paying tax of £83,068 on the £187,500 lump sum at an effective rate of just over 44%. 

Having gone through that reality check, Matt’s open to discussing other options and confirms that he’d only planned on restricting his consultancy income to £30,000 based on his misunderstanding. He has no immediate need of additional income. His adviser suggests that initially, he could leave his substantial pension funds invested across a broad range of investment classes, including property funds, rather than using all his funds on a single buy to let property.

One of the key attractions of buy to let to Matt is the growth potential from property. He hadn’t fully considered that not only would the net rental income be taxable, but he’d have to sell a property to access the capital gains when he’d be liable to capital gains tax. His adviser points out that in contrast, although pension funds can’t reclaim dividend tax credits (like other investors), they otherwise grow free of taxes on the income and capital gains from the underlying investments.

Matt’s also interested in controlling the amount of his income and marginal tax rate. His adviser explains that when he wants to use his funds to provide a pension income, he could use phased flexi-access drawdown. For example, he might start by designating £30,000 of his funds to provide pension income. He could take 25% or £7,500 as tax free cash. For a basic rate taxpayer, that equates to £9,375 of additional gross taxable income. For a higher rate taxpayer, it equates to £12,500. He could draw down on the remaining £22,500 flexibly, taking as much or as little pension income taxable at his marginal rate as he needed. He could repeat the exercise over time. This would give him significantly more control over his income mix and marginal tax rate than rental income from a second buy to let property. Also, the undrawn funds would continue to benefit from a tax advantaged investment environment even after being designated to provide pension income.

He could also consider taking a flexible income via the new option of partial pension encashment (officially referred to as uncrystallised funds pension lump sums). 25% of each such withdrawal would be treated as tax free cash, while the balance would be taxed at his marginal rate of income tax.

Buy to let also drew Matt’s attention because of his concerns about providing pension benefits for Liz and an inheritance for his children. His adviser reassures him that if he dies before 75, all his remaining uncrystallised and drawdown pension benefits can be paid out as a lump sum or as drawdown income to Liz and/or his children, free from tax and outside his inheritance tax estate. If he dies after 75, any remaining funds can be paid via flexi-access drawdown to Liz and/or his children. They’ll have to pay income tax at their own marginal rate on the funds they receive. (This assumes that Matt has sufficient lifetime allowance on death to cover the uncrystallised benefits.)

If he dies after 75, any lump sum payments could be subject to a 45% tax charge, but it’s intended that this will only apply during 2015/2016. Later payments should be taxed on the recipient at their marginal rate of income tax.

Matt realises he hadn’t considered the disadvantages of taking all his pension benefits as a lump sum and relying on buy to let properties to provide him with a retirement income.

He commits to deferring taking his benefits. He recognises that it should be possible to combine tax free cash, flexi-access drawdown and partial pension encashment to provide him with a more tax efficient retirement income when he needs it. He also realises this could offer inheritance tax planning advantages, particularly if it comes to making provision for his children.

Every care has been taken to ensure that this information is correct and in accordance with our understanding of the law and HM Revenue & Customs practice, which may change. However, independent confirmation should be obtained before acting or refraining from acting in reliance upon the information given. This information is based on announcements made in the March 2014 Budget which may change before becoming law.

Taxable lump sum £187,500

Earnings £30,000

Net rental income (existing BTL) £7,500

Net rental income (6 months new BTL) £4,300

£229,300

This would take his estimated total income over £100,000, so he’d lose the £10,500 personal allowance and pay tax as follows (using the announced rates and bands for 2015/2016):

£31,785 x 20% £6,357

£118,215 x 40% £47,286

£79,300 x 45% £35,685

£89,328

Ignoring the taxable lump sum for the purposes of this example, he’d have an income of £41,800 and would benefit from the personal allowance.

£10,500 x 0% £0

£31,300 x 20% £6,260

£6,260

Therefore, the effective amount of tax on the lump sum of £187,500 is £89,328 - £6,260 = £83,068.

£83,068 / £187,500 x 100 = 44.3% effective rate of tax.

£250,000 - £83,068 = £166,932 available lump sum.

More infomation

Retirement