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Pensions tax relief - the latest changes
04 December, 2010

In the Emergency Budget, the Government made it clear that it intended to replace a series of complicated changes, due to start next April, which had already been put into the legislation by the previous Government. Draft replacement legislation has recently been issued, with rules which apply to everyone, rather than targeting high earners.
In the Emergency Budget, the Government made it clear that it intended to replace a series of complicated changes, due to start next April, which had already been put into the legislation by the previous Government. Draft replacement legislation has recently been issued, with rules which apply to everyone, rather than targeting high earners.
 
Annual allowance
 
The main change will be to reduce the annual allowance (AA) from its current level of £255,000 to £50,000 with effect from 6 April 2011. AA is the amount by which the total pension savings can grow each year; above this value the surplus gives rise to an annual allowance charge as the individual’s top slice of income.
 
 
Pension savings
 
Members of defined contribution (DC) schemes, in particular personal pensions (PPs), will need to look at the total of the contributions (whether personal, employer or third party) during the pension input period (PIP) for all of their pension savings. The PIP is usually the scheme year to the anniversary date which falls within the relevant tax year. Members of defined benefits (DB) schemes, such as occupational final salary schemes, will have to work out how much their accrued pension has increased during the PIP (see below for a worked example). Pension scheme administrators will be responsible for providing information to their members on their pensions savings for each tax year if those savings exceed the AA, or at the request of a member.
 
 
Example: Self employed personal pension with AA charge
 
Alison, who is self employed, has taxable income of £110,000 in 2011/12. She is a member of two different PP schemes. Scheme A has a PIP ending on 31 March; Scheme B’s ends on 30 November. She contributes £2,000 per month (£2,500 before basic rate tax relief) to Scheme A and £2,800 per month (£3,500 before tax relief) to Scheme B. She has been contributing similar amounts to these schemes for the previous three tax years. During the tax year ending 5 April 2012, her total pension contributions are:
 
 

Scheme A

(year to 31 March 2010)

£30,000
   

Scheme B

(year to 30 November 2010)

£42,000
Total pension savings £72,000
AA for 2011/12 £(50,000)
Excess subject to AA charge £22,000
 
The AA charge will therefore be £8,800 (£22,000 @ 40%). Alison will have had full tax relief of £28,800 (£72,000 @ 40%) on her pension contributions during the year, so the overall relief is effectively reduced by the AA charge.
 
 
The three year carry forward rule
 
Under the new rules, unused AA for the previous three tax years can be carried forward and added to the current year’s £50,000 AA. For the tax year 2011/12, the first of the new regime, carry-forward will be available against an assumed AA of £50,000 for each of the tax years 2008/09, 2009/10 and 2010/11. The total usable amount is called the ‘available AA’. No carry forward is available from an earlier tax year unless the individual was a member of a registered pension scheme at some time during that tax year.
 
 
Example: Self employed with available AA
 
Michael is self employed. Each year he pays part of his profits into his PP. His contributions have been:
 
2010/11 - £31,000
 
2009/10 - £39,000
 
2008/09 - £26,000
 
In 2011/12 Michael has a good trading year and decides to contribute £92,000 to his PP. He has £54,000 unused AA that he can carry forward to 2011/12. This is broken down and used as follows:
 
 
  Available Used 2011/12
2010/11 £19,000 £7,000
2009/10 £11,000 £11,000
2008/09 £24,000 £24,000
  £54,000 £42,000
 
Michael does not have to pay the AA charge on his pension savings of £92,000. He also still has unused AA of £12,000 that he can carry forward.
 
 
Defined benefit schemes
 
In defined benefit (DB) schemes, individuals accrue a right to an amount of annual pension from pension age. To treat DC and DB schemes in a comparable way, it is necessary to deem the value of notional contributions in a DB scheme. These notional contributions should reflect what would need to be invested in a DC scheme to deliver the extra annual pension accrued in a DB scheme. However, the calculation needs to be as simple as possible so a ‘flat factor’ method will be used. The Government has decided that the level of the factor will be set at 16 meaning, broadly, that an increase in annual pension benefit of £1,000 would be deemed to be worth £16,000.
 
 
Example: DB scheme
 
Nicole has been a member of her employer’s DB scheme for 30 years. The scheme provides a pension of 1/60th pensionable pay for each year of service. In her 31st year, she receives a pay rise from £35,000 to £45,000. 
 
Opening annual pension entitlement 30/60 x £35,000 = £17,500
Closing annual pension entitlement 31/60 x £45,000 = £23,250
Increase in annual pension entitlement  £5,750
Deemed contribution 16 x £5,750 =   £92,000
 
So Nicole may have to pay an AA charge on the £42,000 surplus over the £50,000 limit, depending on whether carry forward relief is available. The contribution is relatively large in this example due to the combination of long service and a large pay rise. 
 
If Nicole had left the scheme after 30 years, then the pension at the end of year 31 would have been uprated by the CPI. If the CPI increase is assumed to be 2.5%, then her pension earned after 31 years would have risen from £17,500 to £17,937, a deemed contribution of only £6,992 (16 x £437).
 
 
The rate of charge
 
The AA charge is due on any pension savings over and above the AA available for the year. The effect of the AA charge is to remove tax relief on any pension savings over the available AA and perhaps also to add a liability on employer contributions.
 
The amount you pay depends on the rate at which tax relief has effectively been given on the excess pension savings, which in turn depends on how much taxable income you have and the amount of your excess pension savings.
 
To find out the amount of your AA charge you add the amount of your excess pension savings to the amount of relevant income you actually pay tax on. The amount of pension saving:
 
• over your higher rate limit will be taxed at 50%
 
• over your basic rate limit but below your higher rate limit will be taxed at 40%
 
• below your basic rate limit will be taxed at 20%.
 
 
Example: Calculation of AA charge
 
John has £10,000 excess pension saving on which he has to pay the annual allowance charge. John also has £142,000 income that he has to pay tax on. The total of John’s taxable income and excess pension saving is £152,000. For the purpose of this example the higher rate limit is £150,000. The basic rate limit is £40,000. £2,000 of John’s excess pension saving is above the £150,000 higher rate limit. £8,000 of his pension saving is above the basic rate limit but below the higher rate limit.
 
John’s tax charge is calculated as:
 
£2,000 @ 50% = £1,000
 
£8,000 @ 40% = £3,200
 
AA charge = £4,200
 
 
Transitional rules
 
It is possible that some individuals will have pension savings relating to a PIP that has already started but which will end in the 2011/12 tax year and so will be subject to the new AA limit. To help individuals in this situation, there will be transitional rules which have effect from 14 October 2010.
 
You might be affected by the transitional rules if the 2011/12 PIP for any of your pension arrangements begins on or before 14 October 2010. You will not be affected by the transitional rules if the total pension savings for PIPs that end in 2011/12 is below £50,000.
 
Where a PIP started before 14 October 2010 but will finish after 5 April 2011, the maximum pension savings you can have in the PIP without paying an AA charge will be £255,000. This will be subject to a maximum of £50,000 pension savings in the period from 14 October 2010 to the last day of the PIP.
 
 
Removal of AA exemptions
 
There will no longer be a blanket exemption from the AA in the year benefits are taken. There will, however, be an exemption in the case of serious ill health as well as death. From 6 April 2011 the exemption from the AA for those with enhanced protection will no longer apply.
 
 
Lifetime limit
 
The lifetime limit, which sets the maximum figure for tax-relieved savings in the fund, currently stands at £1.8m. However, this limit is to be reduced to £1.5m, probably from April 2012. The lifetime limit has to be considered when key events happen, such as when a pension is taken for the first time. If the value of the scheme exceeds the limit a tax charge of 55% of the excess is due.
 
 
The new rules will require careful consideration by many pension scheme members. To discuss how the changes may affect you, please contact us.  We can help with all your financial planning needs and will be delighted to assist you.
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