FSA tells SIPPs firms not to exploit annuity tax loophole

SIPPS firms who are trying to bypass their client’s obligation to buy an annuity with their pension by stripping their fund of cash may face investigation by financial watchdogs.

The Financial Services Authority has warned SIPP providers offering accelerated drawdown schemes face an inquiry if the products are suspected of being marketed, sold or used inappropriately.   

The warning revolves around an annuity avoidance plan that exploits a tax loophole.

UK pension rules say that pension holders must buy an annuity before they are aged 75 or pay a tax charge of 82% on their pension fund.

However, if a pension scheme member makes unauthorised withdrawals from the pension scheme, the tax penalty is 40% and the risk of a surcharge up to 15% - a total tax charge of 55%.

An unauthorised withdrawal is taking cash from a pension fund over and above what the scheme rules lays out as payable benefits.

An accelerated scheme allows unauthorised withdrawals of up to 25% of the fund value per year to empty the fund of cash before the deadline for buying an annuity - the pension firm deducts tax at source and hands the cash to HM Revenue and Customs and the scheme member can spend or reinvest the money he or she receives how they want.

This way, a pension scheme member can pass money from a pension to his family - and probably avoids inheritance tax with the help of intelligent estate planning.

The alternative is buying an annuity that dies with the pension scheme member.

The advantage is obvious with simplified math - if you have a pension pot of £1 million and draw the cash through an accelerated scheme, you lose £550,000 in tax. If you keep the cash in the pension fund and don’t buy an annuity, you lose £820,000.

In the first scenario, you keep £450,00 and in the second, £180,000

Only UK residents need to consider such schemes to avoid an annuity. Anyone with UK pension rights living overseas can transfer their pension in to a QROPS that gives the scheme member no obligation to buy an annuity and places the pension fund outside of his or her estate for inheritance tax purposes.