The interest in buy-to-let property has been fuelled by rising house prices and a perception over many years that pension annuities offer poor value for money. Currently, for an individual age 55, £100,000 pension fund would provide an annuity income of just £4,149 pa on a level basis for life with a 50% dependant’s pension, or £2,599 pa if the annuity provided inflation-protection of 3% pa. [leading market annuity rates correct on 10 March 2015].
So, as residential property cannot be held in pensions, is stripping a pension fund a good idea to match or better the returns available from annuities?
Generally, only 25% pension fund can be drawn out tax-free, eg. if you have a pension fund of £200,000, only £50,000 can normally be drawn as a tax-free lump sum. The remaining £150,000 would be subject to Income tax, in this case at least £53,600 tax or a tax rate of 35.7%. This would leave approx. £146,400 to invest in a buy to let property. Clearly, the buy-to-let property has a lot of ground to make up in terms of investment returns just to recoup the tax hit.
Ongoing, subject to offsetting some expenses against rent for Income tax purposes, rental income is taxable at your marginal rate. Income arising within a pension fund is tax-free (income is only taxed when drawn from a pension). Over time, this gross roll up and compounding of income can be very valuable.
Capital Gains Tax (CGT)
Rental property is subject to CGT on sale, unlike a growth within a pension fund, which is tax-free. Again, the compounding of tax-free gains over time can significantly enhance long-term returns.
Inheritance Tax (IHT)
Once the money has been drawn from your pension fund, it is potentially liable to Inheritance tax (IHT) on your death, which is charged at 40% on amounts over the Nil Rate Band of £325,000 (£650,000 for a married couple). If the money is left in the pension fund, under the new pension rules, it can potentially be passed on tax-free on death. In this example, the £146,400 left after suffering Income tax, would be reduced to just £87,840 after IHT on death, ie. a total of £112,160 or 56% would have been lost in tax.
Unless a pension fund is very large, most people are likely to buy just one buy-to-let house. This means a concentration of investment risk and no diversification, especially when most people’s largest asset is already their home so already have significant exposure to the UK property market.
Whilst the UK housing market has historically generally provided attractive returns, this cannot be guaranteed and those who have suffered problems with negative equity testify. The UK housing market may or may not provide good rates of capital growth in future, this is subject to supply and demand and market forces, as with any other type of investment.
Moreover, irrespective of any potential capital appreciation, there is significant risk with regard to tenants and the potential rental income. How will you manage tenancies? What if there is a void period where the property stands empty? What if a tenant cannot pay, refuses to pay, or is often late with the rent? Whilst many landlords enjoy excellent tenants, there are also countless instances where landlords have experienced significant losses as a result of void periods and difficult tenants.
Then, there are management issues to consider – do you want the hassle of managing a rental property? If you use a property management company, their fees will reduce the investment return for you – fees are commonly 10% pa +VAT for a first rental property. Management can include finding suitable tenants, dealing with the tenancy agreement, collecting rent, house inspections, dealing with maintenance issues etc. This can be time-consuming, onerous and stressful.
Costs also need careful consideration. In addition to the costs of purchase and potential eventual sale (such as Stamp Duty on purchase, legal costs, survey, estate agent’s commission on sale), some new landlords do not carefully evaluate the costs of owning a buy-to-let property. This may include the costs of a management company, noted above, typically 12% rent (including VAT), plus buildings insurance, cleaning and decorating, maintenance. Of course, if the purchase requires a buy-to-let mortgage, then interest costs and set-up costs of the mortgage also need to be included in calculations.
Finally, property is lumpy and can be illiquid. This means that it is not always easy to sell or sell quickly if you need to realise cash, unlike some other types of investment.
Our view is that property should often form part of a diversified portfolio. However, it is a high risk strategy to hold all your wealth in property with your pension income dependent on one tenant; this lack of diversification and the associated risks could apply to any other type of investment. Clearly, if you buy the right property in the right location at the right time, with the right tenant, it can work very well from an investment perspective and deliver the potential for attractive rental income and capital appreciation over time. But, there are lots of ‘ifs’ in achieving this and plenty of scope for disappointment.
Pension Flexi-Access Drawdown
For many clients, if annuities are unattractive and stripping a pension fund to purchase a buy-to-let house is not as appealing as it first seems, Flexi-access drawdown may be worth considering. Drawdown allows a client to leave a pension fund invested and draw income as required each year to support your standard of living at any time from age 55. Of course, the investments for a pension drawdown portfolio need to be carefully managed and risk calibrated to ensure they are capable of supporting a given level of income over time, but this approach ensures that the excellent tax benefits of a pension fund are retained. Moreover, pension drawdown allows for potentially £1.25m to be passed to future generations of the family tax-free, saving up to £500,000 Inheritance tax.
Please note, this article is for information only and does not constitute investment advice. Past performance is not necessarily an indication of future returns; the value of investments and any income from them is not guaranteed and can fall as well as rise; pension rules and tax legislation are subject to change. If you would like investment or pension advice on your individual circumstances, please do not hesitate to get in touch on 01392 875500 or info@SeabrookClark.co.uk