From 6 April 2011, the annual allowance is reduced to £50,000. Deemed contributions to defined benefit arrangements will be valued using a factor of 16 for assessment against the annual allowance. Pension savers are allowed to carry forward any unused relief up to the £50,000 annual allowance for three years. Tax charges arising as a result of exceeding the annual allowance may be settled out of pension benefits. From 6 April 2012, the lifetime allowance will be reduced to £1.5 million though there are options to protect existing pension savings.
Finance Act 2011 ss 65–69 and Schs 16–18 introduce wide-ranging measures that purport to both simplify the UK pensions tax regime and establish a fair and sustainable system for providing tax relief to those saving for retirement in an age of austerity.
These measures largely came into effect from 6 April 2011 and are the latest in a series of legislative changes affecting UK-tax registered pension arrangements since ‘A’ Day.
This article identifies the key changes and examines some of the inherent complexities for UK pension savers as they transition from the old regime.
The annual allowance limits the total amount of tax relievable contributions to or benefits accrued in a UK tax registered pension arrangement during a specified period (referred to as a ‘pension input period’).
One of the key features of the new regime is a significantly reduced annual allowance of £50,000, from £255,000 under the previous regime. There is no current intention to index the annual allowance to inflation.
For defined contribution arrangements, a pension saver is required to aggregate all contributions (both employee and employer) that are made in a pension input period and assess this against the applicable annual allowance.
For defined benefit (final salary) schemes where pension benefits are not directly linked to contributions, it is necessary to value the annual increase in retirement benefits using a flat factor for the purposes of assessment against the annual allowance. Prior to 2011/12 a flat factor of 10 was used, which increased to 16 under Finance Bill 2011.
Even with the benefit of carry forward, a reduced annual allowance increases the likelihood of unexpected charges for pension savers |
From 6 April 2011, any increase in defined benefit pension entitlement linked to inflation is disregarded by reference to movements in the Consumer Prices Index (as opposed to the Retail Prices Index used under the previous regime and which is typically higher).
For example, if a final salary pension entitlement increases from £10,000 to £12,500 and the Consumer Prices Index is 5%, £500 of the £2,500 increase can be ignored. The remaining £2,000 increase is multiplied by a factor of 16 to arrive at a pension input of £32,000 for testing against the annual allowance.
Any increase in retirement lump sum entitlement is added on top to arrive at the total pension input amount.
Contributions or benefits accrued (referred to in UK tax law as ‘pension input amounts’) within the annual allowance limit attract UK tax relief at the individual’s marginal rate; therefore a 50% taxpayer receives tax relief at 50%, a 40% taxpayer at 40%, and a basic rate taxpayer at 20%.
Any excess pension input amounts over the annual allowance are subject to an annual allowance charge. The excess should be reported on the pension saver’s tax return and any tax payable settled via self-assessment.
See Example 1.
Example 1: annual allowance
Looking at an example where an employee and employer contribute £40,000 each to a defined contribution pension plan via regular contributions: before 6 April 2011 the employee would have received full tax relief on the £40,000 employee contribution at their marginal rate of tax and would not have been subject to tax on the employer contribution.
The full £80,000 contribution would form part of the employee’s pension savings which was subject to an overall lifetime allowance of £1.8 million.
The employer would not have been subject to national insurance on the £40,000 contribution made by them into the pension savings and could claim a corporate tax deduction in respect of their contribution.
With effect from 6 April 2011, the employer’s tax position is unaltered. However, the employee is required to aggregate both employee and employer contributions, report the excess over the now £50,000 annual allowance (ie, £30,000) on their UK tax return and is subject to income tax on this excess at their marginal tax rate.
The employee’s pension savings are subject to an overall lifetime limit of £1.5 million. The tax position for the employee on retirement remains broadly the same, subject to the points below regarding purchased retirement annuities.
A pension input period is generally a 12-month period and may be thought of as an accounting year for a pension arrangement specific to the individual member. There is no statutory requirement for it to be aligned to a fiscal year.
To test whether an individual has made the maximum tax relievable pension inputs up to the annual allowance without triggering a tax charge, it is necessary to assess the amount of pension inputs against the annual allowance for the tax year in which the relevant pension input period ends.
An individual’s first pension input period is the 12-month period beginning with the date that contributions were first made into a pension scheme either by them or on their behalf.
For defined benefit arrangements, such as final salary schemes, it is broadly the 12-month period commencing with the date that benefits first started to accrue, although typically a final salary scheme administrator would nominate a pension input period end date to apply to all scheme members.
The subsequent pension input period starts from the day after the first pension input period ends and lasts for 12 months or an alternatively nominated end date if earlier.
A scheme administrator (or in certain circumstances the pension saver) can nominate an alternative pension input period end date.
Under FA 2011, all new UK tax registered pension arrangements will have their pension input periods aligned with the tax year unless an alternative nomination is made. However, this will not affect UK pension arrangements existing before 6 April 2011.
Individuals who are members of more than one UK registered pension plan are required to assess the aggregate of pension inputs in all of their plans during the pension input period or periods ending in a tax year against the applicable annual allowance.
To do so, members will require:
To facilitate this, the Registered Pension Schemes (Provision of Information) (Amendment) Regulations, SI 2011/301, apply information reporting obligations on both pension scheme administrators and employers in the case of employer-sponsored arrangements.
Transitional rules apply for pension input periods commencing before 14 October 2010 that end in the 2011/12 tax year. The purpose of these transitional rules is to maintain the status quo for pension savers who may have built up savings during this pension input period unaware of the reduction in the annual allowance to £50,000.
To address this issue, FA 2011 sets out provisions that subject pension input amounts before 14 October to the higher annual allowance of £255,000, with a reduced annual allowance applying thereafter.
The best way to understand the mechanics of the transitional rules is by way of example. Say an individual’s pension input period started on 1 June 2010 and ended on 31 May 2011. The Treasury’s announcement regarding the reduction in annual allowance for 2011/12 was first made on 14 October 2010 and the pension saver could have contributed more than £50,000 by this time.
The transitional rules apply a higher annual allowance of £255,000 to the period 1 June to 13 October 2010. Any pension inputs on or after 14 October 2010 are subject to the reduced annual allowance for 2011/12 of £50,000 in the expectation that the individual will have reviewed the provision of Finance Bill 2011 and adapted his pension savings behaviour after this point.
The whole pension input period is subject to an overall cap of £255,000 so assuming the individual wishes to make a full contribution of £50,000 on or after 14 October 2010, their pension inputs are restricted to £205,000 in the period from 1 June to 13 October 2010.
Pension savers maximising tax relief available under the transitional rules would need to consider the impact of the anti-forestalling rules, applying to 5 April 2011 if relevant.
FA 2011 introduces a facility to carry forward unused allowances for three years, effective from 6 April 2011. Tax relief up to the £50,000 annual allowance is deemed to have been available from the tax year 2008/09 onwards so that, where individuals have made little or no contributions in the past there is the possibility of relief up to £250,000 in the current tax year. See Example 2.
Example 2: carry-forward relief
To demonstrate this by way of a simple example: a pension saver with a pension input period of 1 April to 31 March makes one-off contributions of his bonus each year into a money purchase arrangement as follows:
2006/07 £50,000
2007/08 £50,000
2008/09 £50,000
2009/10 £30,000*
20010/11 £30,000*
* for 2009/10 and 2010/11 contributions are restricted by the antiforestalling (special annual allowance) rules
In the pension input period falling in the 2011/12 tax year, the individual can make a contribution of £90,000 including £40,000 of carried forward relief from 2009/10 and 2010/11.
A further contribution of £50,000 can be made after 31 March 2012 (in the next pension input period) and if this is made before 6 April 2012 it will be tax relieved in 2011/12, giving tax relief of £140,000 in the fiscal year ending 5 April 2012.
In order to benefit from carry-forward relief, a UK pension saver must have been a member of a UK tax approved pension plan at some point in the tax year for which they are seeking to claim relief, although contributions can be made into any registered pension plan.
The individual must make £50,000 of contributions in the pension input period ending in the current tax year before they can utilise any unused carry-forward allowances.
The impact of the transitional rules and interaction of the anti-forestalling
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Tax relief is given on a first in first out basis assuming that the current year annual allowance is fully utilised so, in the example, if the pension saver made a contribution of only £60,000 in the pension input period ending on 31 March 2012, this would use the current year annual allowance of £50,000 plus half of the £20,000 of remaining unused allowance for 2008/09.
As the amount of carry-forward relief is calculated on a three-year rolling basis, the remaining £10,000 of unused allowance carried forward from 2008/09 is lost as it has not been fully utilised in 2011/12. In 2012/13 they would be able to make tax relievable contributions of £70,000 in total.
FA 2011 contains two further carry-forward provisions principally aimed at extending this relief to internationally mobile employees with savings in relevant non-UK schemes, as defined in Finance Act 2004. Even with the benefit of carry forward, a reduced annual allowance increases the likelihood of unexpected charges for pension savers.
Members of final salary schemes who see a sudden increase in the rate of benefit accrual, for example as a consequence of an increase in pensionable pay on promotion, may be particularly affected. Pension savers may be subject to a cashless tax charge on the basis that they are not yet entitled to receive retirement benefits at the point that the tax charge arises.
Those affected in this way are able to choose to settle any tax charges from their retirement savings under the policy of Scheme Pay.
On 3 March 2011, the Treasury issued a Ministerial Statement setting out the approach to scheme pay, which is where a pension saver may, subject to certain conditions, satisfy annual allowance tax charges from their pension savings. Assuming these conditions are met it will be mandatory for pension scheme administrators to settle tax charges from the individual’s pension savings, if so requested.
Tax charges are required to be settled at the point that they arise and cannot be deferred until retirement benefits are provided.
A further change brought about by FA 2011 is a reduction in the lifetime allowance from £1.8 million to £1.5 million. The lifetime allowance places a limit on the total value of an individual’s pension savings, including investment growth, in all UK tax approved pension arrangements.
Individuals who exceed their lifetime allowance on a benefit crystallisation event (for example when they come to draw down pension benefits) may be subject to significant tax charges of up to 62.5% on the amount of excess over the lifetime allowance.
The government has announced grandfathering provisions that allow individuals to protect their pension savings where these have been built up based on the expectation that a higher lifetime allowance of £1.8 million would apply.
An individual wishing to claim this protection – referred to as fixed protection – must make an election to do so and submit this to HMRC by 5 April 2012 using prescribed form.
Pension savers should be aware that there are conditions attaching to this election – for example, a pension saver cannot continue to contribute or accrue benefits over inflationary growth if they claim for fixed protection to apply.
From 6 April 2011, the requirement to purchase an annuity by age 75 will be removed. Pension savers will be able to leave their pension savings invested in drawdown arrangements (as an alternative to a purchased annuity) and will be able to make withdrawals throughout their retirement.
Withdrawals will be subject to an annual cap which is broadly in line with the amount of annual income that a purchased annuity would provide.
Pension savers who are able to demonstrate that they have a secure source of pension income for life of £20,000 or more will have full access to their drawdown savings without an annual cap, affording them more investment flexibility and autonomy over how this income is invested.
The 25% tax-free lump sum is unaffected by these changes. Any remaining value in an individual’s pension fund is likely to be subject to tax at 55% on death.
The government is clearly mindful of its objective of creating a pensions tax regime in the UK that is sustainable in the long term.
However, it is clear that complexity remains as pension savers seek to assess the impact of the new rules, in particular the effect of a reduced annual and lifetime allowance and availability of carry forward relief and the interaction of these rules with the previous anti-forestalling regime in order to adjust their pattern of retirement saving to maximise reliefs and minimise tax charges in future.
Quite how onerous that complexity will be in practice will depend on the timely flow of information between pension savers, scheme administrators and employers.
Varinder Allen, Financial Services Human Capital, Ernst & Young
