Pensions tax relief: the latest changes explained
The Treasury has announced a significant reduction in the maximum amount of pension savings which will benefit from tax relief.
The government aims to replace a series of complicated changes, due to start next April, which were put on the statute book by the previous government and which targeted high earners.
Instead, the new reduced annual allowance for tax-free pension saving will apply to everyone.
This lower sum is the amount by which your pension pot can grow each year, above which the surplus is taxed.
In order to cut several billion pounds from the tax relief given to pension savers each year, the government has decided that:
- The reduced annual allowance for 2011-12 will be £50,000, rather than £255,000.
- From 6 April 2011 the more restrictive interim allowance of £20,000 for high earners will be removed.
- There will be a carry-forward rule that allows unused annual allowances from the previous three tax years to be used.
- £50,000 of annual allowance is equivalent to a final salary-pension accrual of £3,125, whereas previously £50,000 was equivalent to £5,000.
- The lifetime allowance - the maximum level of benefits that a member can draw from all registered pension schemes without incurring penal tax charges - will be cut from £1.8m to £1.5m from 6 April 2012.
- Tax relief for all pension saving up to the new allowance will be granted at a taxpayer's highest rate of income tax, with any excess taxed as income tax through self-assessment.
Working it out
For people in defined contribution schemes, including stakeholder pension schemes and other personal pension schemes such as SIPPs (self invested personal pensions), working out if they have gone above the new annual allowance will be simple.
They will simply have to add up the total of both employer and employee contributions to a scheme in the financial year.
Increases in the value of these pension funds from investments will not count towards the annual allowance.
Members of final-salary schemes will have to perform a different calculation.
They will have to work out by how much their accrued pension has increased and multiply it by 16.
That sum will be the total that counts towards the annual allowance.
So an increase in pension rights of £3,125 uses up £50,000 of annual allowance.
However the effect of inflation during the year will be removed from the calculations, so it will only be the increase in pension accrual over and above the rise in the consumer prices index that will be taken into account.
The Treasury listened to industry comments that unused allowances should be allowed to be carried forward.
This is to mitigate the possibility of someone getting a nasty shock by being presented with a large retrospective tax bill, simply as a result of getting a modest pay rise after many years of contributions to an employer's pension scheme.
Under the forthcoming new rules, unused annual allowances for the previous three tax years can be carried forward and added to that year's £50,000 allowance.
For the tax year 2011-12, the first of the new regime, the Treasury has said that carry-forward will be available against an assumed annual allowance of £50,000 for the tax years 2008-09, 2009-10 and 2010-11.
Most people, particularly in final-salary schemes, have never had to think about this issue before.
The £255,000 annual allowance was more than enough for them.
HMRC statistics show that only a few hundred people have ever been taxed because their pension pots have grown by more than this in any one year.
Let us first take the example of someone in a defined contribution scheme.
Consider a member earning £50,000 a year where the company contributes 10% of his salary and the member pays 25%.
The member contributions would thus be £12,500 and the employer's £5,000
Total pension savings for the year are therefore £17,500 and there is no annual allowance charge.
If this member is made redundant and the employer agrees to make a redundancy payment of £50,000 to the pension scheme at the end of the year, the contributions would be:
- Member contributions @ 25% = £12,500.
- Employer contributions @ 10% = £5,000.
- Redundancy contributions = £50,000.
Assuming the redundancy payment all went into the pension scheme then total pension savings are £67,500.
The member may thus have to pay the annual allowance charge on the £17,500 of funds in excess of the £50,000 allowance if no carry forward relief is available.
If the person in this example had at least £17,500 of unused relief, he would not have to pay any tax at all.
Consider a final-salary scheme providing a pension of 1/60th pensionable pay for each year of service at retirement.
At the start of the year a member's pensionable pay is £35,000 and he has 30 years of service.
The value of his pension rights at the beginning of year would be 30/60 x £35,000, equalling £17,500.
Multiply that by 16 and you get a £280,000 pension pot.
At the end of the year, his pensionable pay has risen to £45,000 due to a promotion and he now has 31 years of service.
The annual pension at the end of the year would now be calculated as 31/60 x £45,000, equalling £23,250.
Thus the value of the pension pot would be £23,250 x 16, or £372,000.
The increase in pension rights during the year would therefore be £372,000 minus £280,000, or £92,000.
So he might have to pay an annual allowance charge on the £42,000 surplus over the £50,000 limit, depending on whether any carry forward relief is available.
If the person in the above example had at least £42,000 of unused relief, he would not have to pay any tax at all.
Impact of the changes
In the case of redundancy contributions to pension schemes, previous rules did not allow annual allowance charges to be levied in the year the member retired.
This meant that redundancy payments were often used to bolster pension funds of long serving employees who wished to retire once they were made redundant, which was often a suitable solution for both parties.
The Treasury's new rules now mean that the annual allowance will also apply in the year the employee retires, closing off this route in the future, even for mid-level employees.
Long-serving members of final salary schemes who receive promotions or other above inflation pay rises, that push the increase in their pension pot above the annual allowance, may also be liable to tax charges.
Employers will need to make individuals aware of the possible tax charges that may arise so they do not sleep-walk into them.
For individuals in defined contribution schemes, it will be simpler for the individual to deal with.
They can simply reduce their own contributions so that the total contributions are within the revised £50,000 limit.
But care should be taken if the employer is "matching" the contributions by the member so that if the member contribution is lower, the employer contribution is also be reduced.
To make up for this, the member can instead ask the employer to pay part of the pension contribution as additional salary.
Individuals in final-salary schemes will require more help from their company or pension scheme administrators on whether they are likely to exceed the new allowances.
It would be possible for someone to opt out of the scheme.
However this decision is not to be taken lightly and consideration should also be given to whether the employer might provide adequate compensation in lieu of the pension benefits.
Individuals who are members of more than one scheme will need to be more careful as the limits include contributions to all their pension schemes.
It is important that the individuals seek appropriate advice to ensure that they do not exceed the limits and, if they receive other benefits in place of a reduction in pension benefit, to ensure they consider the impact on any taxation.
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