Pension legislation tends to give people a headache

Once upon a time there were eight different pension regimes which caused a great deal of complexity.  Then along came a Labour government which decided the regimes  should be brought together under a set of simplified rules.  This was referred to as “Pension Simplification” and came into effect on what was known as “A Day” (6th April 2006).

At this point most people would assume that this an end to the story, where everyone lived happily ever after  with a set of simplified pension rules. But, unfortunately that was not the case and the same government could not resist further “tinkering” which left the pension rules anything but simple.

When the Coalition government came into power, they decided to revert back to the principle of a simple set of pension rules.  But whether they have actually achieved this is a matter of opinion.

Is it any wonder that pension legislation tends to give people a headache? This article will attempt to set out the rules as they apply for the current tax year and to point out the main benefits and potential pitfalls.

As it stands, an individual is allowed to contribute to a pension scheme and get tax relief at their highest marginal rate, even if they earn in excess of £150,000.

The annual allowance for an individual is £50,000 for the 2011/12 tax year and for the three preceding tax years it is deemed to be £50,000.  The preceeding years are relevant because an individual is permitted to carry forward any unused allowances from the previous three tax years and use them in the current tax year.

There are, however, a couple of conditions in relation to this carry forward.  Firstly an individual has to have been a member of a registered pension scheme during the tax year from which the unused allowance is being carried forward.  He or she will be regarded as a member of a scheme if contributions could have been paid to the scheme by or on his or her behalf, even if no actual contributions were paid in that tax year.  A deferred member of a final salary scheme will also meet the membership test.

The second condition is the maximum amount that can be paid cannot exceed the individual’s earnings for the tax year of payment.

As I am sure some of you will have worked out by now, an individual earning £350,000 who has made no pension contributions in this tax year or the previous three would be permitted to make a £200,000 gross pension contribution.  Given that the individual’s marginal rate of tax would be 50%, the net cost would be £100,000.

So how the calculation made for a final salary scheme member who continues to accrue benefits?  This calculation is undertaken by taking the accrued pension at the end of the previous year, increasing it by inflation (CPI) and deducting this figure from the accrued pension at the end of this year.  The difference is then multiplied by a factor of 16 and any increase in tax free cash added to the resultant figure.  This then gives the deemed contribution for the current tax year

Of course contributions to a pension scheme grow in a tax efficient environment and at the point benefits are taken a Tax Free Cash Lump Sum is available (25% for a non-final salary scheme) with the remainder being used to provide taxable income, typically by way of annuity purchase or drawdown.

For those individuals in a fortunate enough position to have built up very large funds there is a pitfall in the current rules which they need to be aware of.

The maximum amount that can be built up in a pension scheme during an individual’s lifetime is currently £1.8million.  However, this figure is to reduce to £1.5million on the 6th April 2012.

An individual is permitted to retain the £1.8million limit, however they must elect for what is referred to as “Fixed Protection” prior to the 6th April 2012 by completing a HMRC form.  To qualify for the higher allowance no further pension contributions can be made (or accrued in an occupational scheme) after this date.

The value of the scheme is measured against this limit at the point benefits are taken.  Any excess over the allowance, if paid out as a lump sum, or income will suffer a penal rate of tax, for example 55% for a lump sum.

At the point an individual comes to take benefits a new basis has been introduced which is referred to as Flexible Drawdown.

With effect from 6th April 2011, an individual may elect to take their benefits in the form of Flexible Drawdown, where there is no restriction on the maximum income that can be taken in each year.

This election can only be made if the following conditions are met.

  1. The individual has other guaranteed pension income of at least £20,000 per annum.  This includes the State Pension, any Occupational Pensions or Annuities but excludes any type of Income Drawdown.
  1. No contributions have been or will be made to a money purchase arrangement for the individual in the tax year of the election, and
  1. The individual has ceased to be an active member of a defined benefits scheme before making the election.

In addition, any further pension contributions accrual after an election for Flexible Drawdown will be subject to an annual allowance tax charge.

As with any other withdrawals from a pension after the tax free cash has been taken, Flexible Drawdown will suffer income tax on the member at their highest marginal rate.

I can certainly see this as being of use to a number of individuals as it creates great flexibility over when they drawdown from their pensions thereby allowing greater control over the tax point and also being able to withdraw lump sums when they are needed, for example for such events as weddings.

Tax relief on pension contributions may also be available for certain individuals at a rate of 60%.  This rate is available when a contribution is made such that it effectively reduces an individual’s income from above the limit whereby their personal allowance for income tax has been lost to below that limit.  The upper limit being £114,950 with the lower limit being £100,000.  This is because for every £2 of income above £100,000, an individual loses £1 of their personal income tax allowance.  Therefore, when they reach £114,950 they have lost their £7,475 personal income tax allowance for the 2011/12 tax year.

If you therefore take the example of an individual earning £114,950, who makes a gross pension contribution of £14,950, they will reduce their income down to a limit which gives them back their personal allowances and they will also obtain 40% income tax relief on the pension contribution.  The combination of the 40% income tax relief on the pension contribution and recovery of the personal allowances gives a combined income tax relief of 60%.

The above gives you a brief insight into the current pension rules and I would hope that once you have read this article you come away thinking that some of these reliefs are quite generous.  Based on recent press speculation, how long 50% or even 60% tax relief will be available on pension contributions in these times of austerity I do not know.

It should also be remembered that you do not have to invest in the bad old insurance companies funds and can in fact utilise a self-invested personal pension appointing your own managers or investing in your own commercial property.

Given the fact that we all have to save for our retirement I hope you will agree that a pension is not something that should be ignored but something that should be used for its intended purpose.

If you need to discuss your pension requirements, call us on 0161 832 4451.