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By Emma Tyrrell

In six months time, pensions get a whole lot more flexible. From April 6 next year individual investors will be able to hold residential properties within a self-invested personal pension (Sipp), as well as "alternative" investments like wine, classic cars, and racehorses.

The relaxation of the rules has got a lot of people very excited, but there are fears that naïve investors may be sucked in by the benefits, without understanding the many pitfalls. Already there are stories of property firms advertising investment flats at an "effective" discount of 40 per cent, because of pension tax-breaks, without pointing out the drawbacks.

Sipp sales are not yet regulated by the Financial Services Authority, and Government plans to bring them under the FSA's remit are not expected to take effect until April 2007, a full year after the new rules come in. That's a year in which almost anyone can sell a Sipp, and experts are worried that this could leave consumers at risk from rogue or inexperienced salesmen.


What are Sipps?

Self-invested personal pensions tend to operate at the bespoke end of the pensions market. They offer massive investment choice and control, allowing investors to pick individual shares, bonds, unit trusts, Oeics, investment trusts, insurance funds and commercial properties such as offices or shops.

Costs used to be heavy, but low-cost Sipps have emerged in recent years, alerting many ordinary pension investors to their benefits.


And what's changing?

From April 6 2006, the new single regime for all personal and occupational pension schemes will bring Sipps into line with other much larger types of pension, which can already invest in residential properties and alternative investments.

This will mean that Sipp investors could buy residential property such as a buy-to-let flat or holiday home with their pension funds, as well as more esoteric investments like antiques, art, stamps, gold, jewellery, and yachts.


What about my collection of nude Victorian photographs?

In theory, yes. Sipp providers have already had some interesting requests from collectors wanting to shelter their possessions from capital gains tax, including vintage clocks, military swords, Marilyn Monroe posters, even a Pokemon collection. In practice, however, many Sipp providers are likely to restrict their list of new allowable assets to property.


What are the advantages of all this?

In short - the tax breaks. The upfront tax relief on pensions means that for every £78 you pay into your pension fund, the Government pays in £22. Higher rate taxpayers, who receive 40 per cent tax relief instead of 22 per cent, can also claim back a further £18, making their net contribution just £60.

This is why property companies are able to advertise properties at an effective discount of 40 per cent. From April, when investors can contribute up to £215,000 a year to their pension, you could in theory bung £100,000 into your pension, costing you £60,000, and use that £100,000 to buy a nice little buy-to-let flat. In fact, as Sipps will also be allowed to borrow up to 50 per cent of the fund value, you could even use a mortgage and buy a £150,000 property – all for that initial investment of £60,000.

On top of the upfront relief, investments held within your pension fund should also be free from income tax and capital gains tax.


OK, so what aren't you telling me?

Well, for a start, all investments in your pension fund are owned by the pension fund trustees, not you. If you want to stay in "your" holiday home, or to drive around in "your" 1966 Alfa Romeo Spider, you will either have to pay a rent to your pension fund for the privilege, or be hit with a benefit in kind tax charge.

As far as a holiday home goes this means you must pay the full market rent whenever you want to use it. If you don't, you will not only be taxed on the notional benefit you've received by not paying it, but also on an additional 5 per cent of the property's market value over £75,000, pro-rata.

Property investments must also be placed with a letting agent, or else the taxman will take the view that you still have day to day control of the property and will tax you for the whole year. In practice Sipp providers are likely to have their own approved letting agents, and will insist the property is placed with them.

If we're talking alternative investments like art or wine, you must show that you have no everyday access to them. Locking them in your attic or cellar is not enough, they'd have to be loaned to a gallery or held in a bonded warehouse. Hang that piece of art above your fireplace, and the Revenue will treat you have enjoying a benefit worth 20 per cent of its value each year. You'll either have to pay that 20 per cent to your pension fund, as rent, or be taxed at 40 per cent on it, meaning that if your pension fund owns a £50,000 work of art, you'd either have to pay £10,000 a year rent to your pension fund or £4,000 a year tax, for the privilege of hanging it in your home.

And that's not all. If the investment is seen by the taxman as having a life of less than 50 years – and that includes cars, yachts, wine, racehorses and so on – it will also be taxed as a wasting asset, meaning you have to pay an additional 15 per cent tax on that notional benefit, pushing the charge up to 55 per cent tax on 20 per cent of the asset's value each year.

All in all if you want to enjoy your collection, don't stick it in your pension fund. If it's a pure money making investment, however, that's fine.

If you are interested in alternative investments, make sure you check out any tax breaks which may be available outside pension funds. Wine, for example, is usually exempt from capital gains tax anyway.


Can I use pension fund money to buy myself a home?

You could, but in almost all circumstances it would be an extremely dumb thing to do. For a start you'd have to pay rent to your pension fund for living in the property, or be taxed on the benefit. You would also have to get permission from pension fund trustees to make any changes to your home.

In addition, the tax advantages are reduced. Your main family home is exempt from capital gains tax when you sell it anyway, meaning there is no CGT advantage to sticking it in a SIPP.

On top of that, the pension fund would probably have to sell the property when you retire, in order to pay out your 25 per cent tax-free cash and to provide the money to buy you an annuity retirement income. If your property was worth less than a quarter of your pension fund at retirement you could possibly get a short-term bridging loan to buy back your home from the pension fund, paying off the loan when the pension pays out your tax-free cash.

Weighing the smaller benefits against the massive amount of hassle, it's just not worth it.

Can I transfer a property I already own into a Sipp?

Yes, but if it is not your own home, this will trigger a capital gains tax charge on the sale to the pension fund.

Even so, people transferring existing buy-to-let investment properties are likely to be the biggest group to take advantage of the new Sipp rules. Hundreds of thousands of people are already using buy-to-let as a way of saving for retirement, but without the tax breaks.

They may take a view that a smaller CGT bill now in transferring property into a Sipp, is a price worth paying for sheltering future rental income and capital appreciation from tax.

Remember though, that rental income will go straight into the pension, albeit tax-free, so you won't get the immediate benefit

Also, if you want to sell the property, the proceeds will remain within your Sipp to be reinvested. You can't get your hands on the money until you retire and take benefits, at which point you can take up to 25 per cent of your fund as tax-free cash, using the rest to provide a taxable income.

Another point to consider is that although you can make investment decisions, such as whether to buy or sell the property, the day-to-day management is the responsibility of the pension fund trustees.

Can I buy overseas property?

You can, and cheap euro mortgages may make the idea appealing. However, many Sipp providers are only likely to allow this in popular areas, because of the difficulty of finding local managing agents.

Also, while property in your pension may be exempt from UK income and capital gains tax, you may have to pay foreign tax on any rent or growth in value.

You're also likely to have to pay higher charges to invest in overseas properties, particularly in countries like France and Spain , which do not recognise British trust laws and therefore would require pension schemes to hold property via separate companies.

Again if the property is for your personal use, you would either have to pay a market rent to your pension fund, or be taxed on the benefit.

So is investing in property or alternative investments via a Sipp a good idea for me?

If you have to ask the question, you probably need proper advice from an independent financial adviser, specialising in pensions.

The tax-breaks may make it a great idea for some, but only if they go in with their eyes open to the pitfalls. Most of these will arise if you want to enjoy some benefit from the investments, other than simple financial gain. Those who view their pension holdings as pure investments face fewer drawbacks.

Generally speaking, buying property within a Sipp is only likely to be suitable for middle and higher earners, as you'll need to be able to afford to pile enough into your fund, to not only buy a property, but to ensure that it is not the bulk of your pension investments. Putting all your pension eggs in one house-shaped basket is a risky investment strategy.