How to help clients borrow money from their pension

Clients look forward to the time they can get their hands on the money they’ve saved for years in their pension.

Most can obtain 25% of this tax free. But this is not always used for retirement.

In fact, it can be freed up for all manner of things – and its use will determine the next tax-efficient steps to take.

The following case illustrates how business owners can borrow money from their pension in the most tax-efficient way.

The case

Amrit is aged 57 and owns his own limited company. He’s taking a combination of low salary with dividends just up to the higher-rate threshold for income tax. He’s looking to purchase a commercial property for this company to be based out of and is looking to spend about £100,000 on the purchase.

He and the company both have the money for the extra charges, such as conveyancing and stamp duty. In his area, commercial properties are sold very quickly, so speed is of the essence.

Amrit is aware of a property that has just come onto the market within his price range and he’s keen to put an offer in. He’s arranged to see a financial adviser to discuss the options for purchase.

During the fact find, it turns out Amrit has £400,000 in a Sipp. His adviser may think about this as a tax-efficient way to purchase commercial property, but it’s not the quickest.

Commercial borrowing could also be considered but, again, time constraints could be an issue, and there is also the fact that, due to interest being added, it may not be the most cost-efficient.

The Sipp almost seems ideal, as it is £100,000 that is needed and, as Amrit has never taken benefits from his pension before, it’s within the new lump sum allowance and lump sum and death benefits allowance, so can be easily accessed.

But what do we do with this £100,000 once it’s withdrawn?

Amrit could just take the pension commencement lump sum from his Sipp to cover the cost of the purchase in his own name. This will meet the criteria for speed, but will it be very tax-efficient?

The company will have to pay rent on this, which is then taxed as earned income on Amrit personally. This will then have the knock-on effect on the tax efficiency of taking a low salary and dividends to meet the rest of Amrit’s needs. This may even push some of his dividends into the higher-rate band (33.75% dividend tax in the higher rate as opposed to 8.75% in the basic rate band).

There is a way this could be done more tax-efficiently. He could take the £100,000 tax-free from his pension and make a director’s loan of the same amount to his company. This gives the company the money required to make the purchase and will save the company having to pay rent, building up more profit in his business.

The best part is that, when there is enough money in the business, it can be paid back to Amrit free of tax, as the business is simply repaying the loan.

However, he does lose tax-free cash from his pension, but it’s just shifted where this is being held to his company. As the business doesn’t have this spare money, though, it may take a while to build this up.

The adviser’s strategy is twofold, as the director’s loan ensures the process moves at speed. But, what if, behind the scenes, the Sipp was also preparing to purchase the property from Amrit’s company?

This would limit the growth on any property gain being charged to corporation tax from Amrit’s company and ensures any future gains are tax efficient (there is no tax on the gain inside the Sipp).

The rental money (which would be corporation tax deductible) could then be paid to the Sipp and build up more pension commencement lump sum for Amrit to have in the future. The downside would be there is two times the ancillary costs (conveyancing, stamp duty, etc.), but, over time, the tax-efficiency should pay off. That’s the cost for having to move at speed.

And the cherry on top is the business then has the £100,000 back and can repay the loan to Amrit at any time he finds this to be convenient.

Mark Devlin is senior technical manager at M&G Wealth