Should you cash in your pension to buy-to-let?
If you’re thinking about joining the ranks of the ‘silver landlords’, Steve Carlson of Carlson Wealth Management has plenty for you to think about. In the first of a two-parter, he compares the benefits of buy-to-let property with simply drawing money from a pension.
So which is better – pension or property? I’m sure you’ve either thought about this question yourself or you know someone who is thinking about it.
If you’ve read anything on the subject written by a pension company, then they’ll have already told you that it’s a crazy idea. Conversely, anything written by an estate agent will tell you that you’d be a fool not to. Okay then…
So what’s the truth?
Well, the truth is that the answer will be different for everyone.
And to show you how true that is, I’ll walk you through an example.
Mr Jones is 65 and has just retired. His total state pensions come to £7,500 a year, plus he’s got a Final Salary Pension of £4,500 a year. He’s also got a collection of other work and private pensions that together are worth £250,000, and he’s trying to decide what to do with the money.
OPTION A – Buy a Property
Mr Jones could take all of his pension out in one go, and use the proceeds to buy an investment property. He believes he understands property, because he’s lived in one all his life.
The investment properties in his area are selling for around £160,000 and are achieving a rental income of £800 a month, which is a gross yield of 6 per cent and after all his expenses, he will get a net yield or income of 5 per cent.
When he takes the money out of his pension, 25 per cent of it (£62,500) will be tax free.
The other 75 per cent (£187,500) will be taxed as income.
He will pay effective rates of tax on a sliding scale of 20 per cent, 40 per cent, 60 per cent and 45 per cent, so his total tax bill will be a whopping £75,175!
This means that after tax he will be left with £174,825
Buying a property
Mr Jones allows himself a budget of £14,825 to pay for solicitor’s fees, stamp duty (now he’s got to pay the extra 3%) and furnishing the property before he rents it out.
He buys a property for £160,000 and rents it out for £800 per month, which gives him a gross rent of £9,600 per year (i.e. 6 per cent gross yield).
He has average expenses of £1,600 per year so is left with £8,000 (5 per cent net yield).
He has to pay income tax at 20 per cent on his profit, so after tax he will get:
Net income: £6,400 per year
OPTION B – Withdraw money from his pension
Mr Jones decides to explore the option of leaving his pension fund invested and withdrawing a monthly income from it.
His financial planner does some calculations based on how much risk he feels comfortable taking and a variety of other factors. Mr Jones has a ‘cautious’ attitude to risk and is in good health, so in order for his money to last until age 100, his financial planner advises him that he could take out a fixed amount of £1,100 a month from his pension, which would be £13,200 a year.
His alternative is to take a lower initial income of £8,500 a year, and increase this amount by 2 per cent a year to allow for inflation
25 per cent of that income will be tax free, and the other 75 per cent will be taxed at 20 per cent, so after tax he will get:
£11,220 per year (level)
£7,225 per year (increasing by 2%)
So which one is best for Mr Jones?
On those figures, withdrawing money from his pension would certainly give Mr Jones a higher net income than a buy-to-let property. However, there are a number of other factors that Mr Jones should consider. Here are the main ones:
|He will have to find, buy, decorate/furnish the property and find his first tenants||A couple of meetings with his financial planner|
|Collecting rent, complying with legal obligations, house inspections, dealing with issues with tenants, maintenance/repairs, finding new tenants. A lot of this could be outsourced to a letting agent, although this will reduce his income.||An annual meeting with his financial planner|
Flexibility of income
|There is none. Mr Jones will get whatever rent is paid.||He can vary how much money he takes.|
|There is the possibility that the tenants won’t pay the rent, or he has void periods where the property is empty.||The pension can continue paying him an uninterrupted income.
|Historically rents have usually increased over the long term, so the rental income should provide some protection from inflation.||He has the choice of taking a higher initial income without any inflation protection, or can choose to take a lower amount and increase it every year so it keeps pace with inflation.|
Risk of running out of money
|Mr Jones would only be spending the rent, and would leave the capital (the house) untouched. Providing that the house is still standing and he can find paying tenants, then he won’t run out of money||Although Mr Jones’ financial planner used prudent assumptions in his financial plan, there is the risk that his pension could perform worse than expected and he could run out of money before age 100.|
What will be left when Mr Jones dies?
|Mr. Jones ‘s family would inherit the house. Initially the house would be worth £160,000, although the value may increase over the long term.||If he were to die shortly after drawing his pension, then he would leave a pension of £250,000. This amount would reduce over time as he withdraws money from his pension.|
|If the rest of Mr and Mrs Jones’ estate is over £650,000 then on their death, the rental property would be subject to 40% IHT||The pension would not be subject to any IHT on his death. If Mr Jones dies before age 75, then his beneficiaries will be able to take the money out tax free. If he dies after age 75 then the money will be taxed as income when his beneficiaries receive it|
As you can see there are a huge number of factors to take into consideration, and this list is by no means exhaustive!
Mr Jones is horrified at the thought of paying £75,175 in tax as that would mean he would instantly lose 30 per cent of his pension. But stay tuned for part 2, when he consults his financial planner about a third option…
In the meantime, you can find your financial adviser at unbiased.co.uk.
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Steve Carlson is a Chartered Financial Planner and Tax Adviser and the founder of Carlson Wealth Management. Based in Cardiff, he advises clients across the region, with a particular specialism in pension planning, pension scheme benefits, investing for retirement and retirement options. As an IFA he also provides a full range of other financial and wealth management services.