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The purpose of this Memorandum is to explain the advantages and disadvantages of self-invested personal pension schemes (SIPPs).
What is a SIPP?
A SIPP is a money purchase personal pension scheme. The usual pension scheme benefits of a tax free lump sum (generally 25% of the fund), pensions and death benefits can be paid. Membership is generally open to anyone with taxable earnings in the UK who is self employed or employed, including directors. Transfers from other pension schemes can be accepted even if there are no taxable earnings.
SIPPs were originally designed for large funds, with a comprehensive range of investments. In recent years, any personal pension scheme that offers a choice of investment funds calls itself a SIPP.
Administration costs will be based on the type of SIPP selected. A full SIPP offering a wide range of investment types will have significant fees and so they are best suited to high net worth individuals.
SIPPs can be funded by personal contributions from the member, an employer’s contribution (for employees) or transfer payments. Employer contributions may be more efficient to reduce any National Insurance liability.
Employer contributions and members’ personal contributions are usually eligible for tax relief. Tax may be charged if the total input exceeds an Annual Allowance of £50,000.
More details are provided in the separate Client Memorandum ‘Income Tax Relief on Pension Contributions’.
Generally, SIPPs do not pay tax on income generated on investments (interest and dividends) and do not pay capital gains tax.
SIPPs may invest in a wide range of investments which are chosen by the member. A full range of investments offered by a SIPP would include commercial property, equities, gilts, managed funds, unit trusts, structured products and deposit accounts.
Loans to the SIPP member, his employer or his business are banned. High tax rates apply to residential property which effectively preclude its inclusion in a SIPP (see below).
Some SIPPs will restrict the options that they offer to members.
SIPPs can invest in shares directly, perhaps via a stockbroker’s execution only service or via a discretionary managed portfolio or via a unitised fund.
An individual holding quoted shares may wish to consider selling them and paying the proceeds to his or her SIPP as a contribution. The disposal occurs at market value, but any capital gains may be covered by the individual’s annual exemption (currently £10,100) or by existing capital losses.
SIPPs may invest in unquoted shares, and there is no restriction on the size and value of an unquoted shareholding held by a SIPP. However, it would be most advisable to obtain a clearance in advance from HMRC under the transactions in securities legislation, if a SIPP is acquiring more than a small minority holding.
If the member controls or is connected with the company then the rules relating to taxable property (see below) may effectively prevent the SIPP holding the shares.
SIPPs may invest in commercial and industrial property whether situated in the UK or abroad. Commercial property of any kind can be a useful planning tool when leased to the family company or the member’s business or partnership.
The company or business obtains tax relief on the rent it pays and the rent received by the SIPP is tax free. Income tax will be suffered when a pension is drawn but the tax is deferred and could be at a lower overall rate. The facility to purchase offices for a partnership can be very useful. The purchase may be funded from new contributions, borrowings or transfers from other pension schemes. Because a SIPP is free of Income Tax on the rent it is more efficient when using a loan to purchase a property as the rental stream can be used directly to reduce a debt. An individual would have to pay Income Tax before reducing the debt.
The ownership of the property by the trustees protects it from any liquidator of the business. If commercial property is leased to the member’s business, it must be on fully commercial terms, otherwise a tax charge will arise on the member on the value of the “benefit” so enjoyed.
The pensions legislation effectively prevents SIPPs from investing in residential property and ‘tangible moveable property’, by applying punitive tax rates. Tangible moveable property includes personal chattels, such as works of art, antiques, fine wines, jewellery, yachts, commodities, etc but also includes business related items such as computers and machinery. Basically it is anything that you can touch and can be moved.
The legislation also extends to indirect investment in residential and tangible moveable property which includes, subject to a few exemptions, shares in an unquoted company that owns such property.
Transactions with Connected Parties
SIPPs can buy property from a member; sell it to members; lease property to members and to partnerships of which the members are partners; and own property jointly with members and partnerships of which the members are partners. These transactions must take place on fully commercial terms.
There is also the opportunity for directors or partners to own their property jointly via their SIPPs. The SIPP can sell a share of a jointly owned property to another partner’s SIPP, a useful facility on the unexpected death of a member where investments have to be realised to pay benefits.
SIPPs may borrow up to 50% of the net value of the fund. There are no conditions attaching to the use to which the borrowing may be put. It may be used to purchase a property or to fund drawdown payments. The limit applies each time new funds are borrowed but it does not need to be tested at other times.
The lowest age for drawing benefits is age 55. There is no upper age.
One of the main attractions of a pension scheme is that 25% of the fund value can be taken as a tax free lump sum when benefits are drawn, as long as the member does not exceed the lifetime allowance from all schemes. The lifetime allowance is £1.8m for the tax year ending 5th April 2012. It will reduce to £1.5m from 6th April 2012. Members will have the option to register to retain the limit of £1.8m, as long as no further contributions are made.
If the value of a person’s benefits exceed the lifetime allowance as the benefits start, then an additional tax charge of 25% is levied on any extra fund used to provide pension or 55% on lump sums.
Pensions are taxed through the PAYE system in the same way as earned income but no National Insurance contributions are suffered. The member may suffer higher rate tax before retirement but be a basic rate payer after retirement meaning that 40% tax can be saved on contributions and 20% paid on the pension, at current rates.
Many people buy an annuity at retirement to provide certainty of income. However, some people would prefer the flexibility to keep their funds invested and withdraw funds as they need them.
Drawdown is a form of pension where an upper limit is set and the member chooses the amount of pension each year between zero and the limit. The limit depends on the member’s age and yields on gilts and is re-calculated at least every 3 years. It is based on the amount that might otherwise be secured by a single life annuity. There is no minimum amount that has to be drawn, at any age.
There is no requirement to buy an annuity at any age which is, therefore, at the SIPP owner’s discretion. There are no restrictions on the investments that can be made during drawdown but there is a need to manage liquidity to make the pension payments.
If a person has secured a minimum income (defined below), then extra funds can be drawn, in excess of the normal drawdown cap, with no limit. This is referred to as Flexible Drawdown. Such payments will be taxed as income, in the same way as capped drawdown. Because the payments will be in addition to existing income and are likely to be larger than normal income, the payments may take the person into higher income tax rates (40% or 50%).
The minimum level of current secure pension income required is £20,000 p.a. Income from sources other than pensions will not count. The following sources count:
Death in Drawdown
On the death of a member, any surviving spouse can continue drawdown in the scheme. Any drawdown funds paid as a lump sum are taxed at a rate of 55% and are not subject to inheritance tax. Funds not in drawdown would still be paid tax-free on death.
FOR GENERAL INFORMATION ONLY
Please note that this Memorandum is not intended to give specific technical advice and it should not be construed as doing so. It is designed to alert clients to some of the issues. It is not intended to give exhaustive coverage of the topic.
Professional advice should always be sought before action is either taken or refrained from as a result of information contained herein.