Clients can be wary about putting money into pension funds. They are often put off by the poor rate of return on equities, coupled with the fact they will only ever get at 25% of their cash and are ultimately forced to buy an annuity.
The statistics certainly bear this out. According to estimates from the National Association of Pension Funds only one in three adults has a pension. Our research shows just 12% are currently making additional savings for their retirement outside a pension. Put simply, the evidence suggests people may not be taking a balanced view of the investments which will fund their retirement and might be leaving it too late to do much about it. One option which continues to remain popular as an addition to a personal or occupation pension is property ‘ particularly residential buy-to-let.
A recent Financial Times article notes the average house has increased in price over eight times since 1973. It also points out that buy-to-let investments can give a rolling yield of rental income of between 7% and 8% ‘ enough to reduce a mortgage of about 6% before capital growth is taken into account.
Capital growth continues to be healthy. Recent figures issued by Halifax show the rise in house prices for the year to March 2002 was 16%. Although this is not expected to continue, Halifax predicts that the rise for 2002 will still be 7%.
There are three main drawbacks with buy-to-let for the higher rate taxpayer. The first is that the rental income, net of expenses, will be taxed at 40%.
The second is that if the property is sold, any capital gain will be subject to Capital Gains Tax (CGT) at 40%, subject to availability of the annual exempt amount.
The third is that if the property is still held at death, its capital value will almost certainly be liable to Inheritance Tax (IHT) at 40%. If the owner has been unfortunate enough to sell the property and then die they may well have to pay out for both CGT and IHT. However, there is a way to either mitigate or eliminate these problems for clients who are running profitable limited companies. The answer lies in a funded unapproved retirement benefit scheme (FURBS). Here are some answers to frequently asked questions:
What is a self-administered Funded Unapproved Retirement Benefit Scheme?
It is a company sponsored pension scheme which is established under trust for the benefit of employees. The members of the scheme are appointed as trustees and retain control of the investments.
Is a professional trustee required?
No, according to the legislation, but for practical administration purposes the answer must be ‘yes’. it would be wise to use a professional pension trustee.
What services are provided?
Professional trustees provide all the legal documentation needed to set up a FURBS and all services relating to its ongoing administration. Although called an ‘unapproved’ scheme, each FURBS requires individual approval from the Inland Revenue.
How quickly can a FURBS be established?
Having determined a FURBS is appropriate it can be established in a matter of days.
What are the tax advantages?
The contributions paid by the employer are treated as an expense against profits and will normally qualify for tax relief in a similar way to those paid to an approved scheme.
Contributions paid by the employer are regarded as income in your client’s hands and are treated as a benefit-in-kind ‘ taxable at the client’s marginal rate. However, as we have discussed, the contributions will normally obtain full corporation tax relief. Contributions into a FURBS will also be subject to national insurance charges.
The investment income within the FURBS is subject to basic rate income tax currently 22%, rather than the personal higher rate of 40%.
Dividend income and interest on deposits is taxed at only 20%. The FURBS has an exemption to CGT, restricted to 50% of a personal annual CGT exemption.
Any CGT is restricted to 34% and taper relief applies. On retirement ‘ normally between the ages of 50 and 75 ‘ the trustees of the FURBS may pay the benefits to your client as a lump sum free of any taxation. It is also possible to provide a pension, but in general, this will not be tax-efficient as it will be taxed in full as earned income.
Is it expensive to set up a FURBS and how much does it cost to run?
The initial fees and annual management fees are not linked to the level of contribution or the value of the fund. This means the larger the contribution or fund, the more cost effective a self-administered FURBS is ‘ compared to a typical insured approved pension arrangement.
What are the maximum benefits that a client can look forward to on retirement?
There are no restrictions on the benefits provided by the FURBS. These will entirely depend on the investment success of the trustees and the level of contributions paid.
When can a client claim benefits?
On leaving service after age 50 or at retirement. The rules allow for an individual to retire at any age from 50 onwards. Benefits must normally be taken by age 75 although in certain circumstances this can be deferred.
What protection does their family have should a client die before retirement?
The trustees are allowed to pay out the entire fund to your client’s dependants in the form of a lump sum. As this is paid out under the ‘rules of a discretionary trust’ it does not form part of your client’s estate, and therefore escapes IHT. A client may nominate whoever they wish to benefit.
What investments are allowed?
As the FURBS is, by definition, an unapproved scheme there are virtually no restrictions on how the fund can be invested. Investments largely fall into two areas, connected and unconnected.
Connected investments are those that can assist your client’s company. Any such investment must be on a commercial basis. A FURBS can, for example, lend 100% of its assets to the employing company. The trustees are allowed to borrow money in order to facilitate the purchase of an investment and there is no Inland Revenue limit on borrowing.
Unconnected investments are varied but they include residential property, which can be rented out.
Can contributions vary?
The level of contribution to a FURBS can be determined each and every year and there is no penalty for not making a contribution in any particular year or years.
Does the FURBS require accounts?
The trustees must keep account of all funds within a FURBS and must prepare and submit the annual tax return to the Inland Revenue (usually through the company’s accountants).
What happens to the FURBS if the company fails?
As the fund is held under trust and is a separate legal entity to the company, its assets cannot be claimed by company creditors.
So there are savings to be made by paying money into a FURBS rather than taking it as a personal bonus. On the investment income there are annual savings of 18% or 20% per annum for higher rate taxpayers. The CGT rate on any capital gain is 34%, not 40%, while clients can receive the whole of the fund tax-free at retirement. Finally, any funds in the FURBS at a client’s death escape IHT.
A recent industry report noted that tenant demand is strong for two bedroom properties. A total of 80% of rental properties on letting agents’ books are let within six weeks and in certain hot spots such as Horsham and High Wycombe, lettings are achieved in a week.
These figures indicate the best gross return ‘ an average of 7% ‘ is on two bedroom flats. This rises to 8% on the south coast and Glasgow, 9% in the Midlands and 10% in the North West.
The CML notes that demand for buy to let will be driven fundamentally by the need for privately rented property. It believes that net inward migration, and increases in one-person households as a result of divorce and increasing longevity, point to fairly strong growth in household numbers for the UK going forward. Changing labour and lifestyle patterns such as greater emphasis on job mobility and individuals becoming homeowners at a later age, represent positive factors for the private rented sector.
The combination of a healthy market and the tax advantages offered by a FURBS make buy to let an attractive proposition for those of your clients who run limited companies and are looking to broaden their investment portfolio.
Steve Sandiford is head of borrowing products at BM Solutions
More individuals are looking at buy to let as a means of supplementing their retirement income.
Net inward migration, high levels of divorce and increasing job mobility suggest demand for rented accommodation will remain strong.
A FURBS can reduce Income Tax, Capital Gains Tax and Inheritance Tax paid by higher rate tax payers with limited companies.