Jeremy Goodwin (Eversheds) answers questions on recent developments in pensions taxation following the Budget and considers the current HM Treasury consultation.
Since George Osborne’s March 2014 Budget, the pension tax regime has seen some substantial changes, with further seismic shifts still under consideration in a HM Treasury consultation which runs until 30 September.
What changes have already been announced?
For pension lawyers, the new pension flexibilities introduced at the start of the current tax year were the headline news. These opened up drawdown to all money purchase pension savers, regardless of the size of their pension pot, and also allowed pension benefits from money purchase pots to be drawn purely as cash (the new uncrystallised funds pension lump sum or UFPLS). In both cases, the saver can benefit from the usual 25% tax-free cash amount. This can be taken upfront when using drawdown: if taking benefits as one or more UFPLS payments, 25% of each cash payment is tax free.
However, from a pure tax perspective, the key developments to date – in the sense of savers paying more (or less) tax – have been the recent changes to the treatment of death benefits, and to the lifetime allowance (LTA) and annual allowance (AA) regimes.
Who stands to gain from the changes?
The clear winners, in tax terms, are the recipients of death benefits. If unused money purchase pension savings (either uncrystallised funds or undrawn funds held in a flexi-access drawdown arrangement) are taken in the form of drawdown by the beneficiary, these are payable entirely free of income tax where the pension saver dies below age 75, provided that the beneficiary’s drawdown arrangement is set up within two years of the date when the scheme administrator first knows (or ought reasonably to have known) of the saver’s death.
If the pension saver is aged 75 or over at the date of death, or if the beneficiary’s drawdown arrangement is set up outside this two year window, the beneficiary’s drawdown income is taxable at his/her marginal rate. Unused funds can be passed on upon the beneficiary’s death, with the same tax rules applying (by reference to the beneficiary’s age at death). In a new departure, the pension saver or beneficiary can nominate the intended recipient, rather than payments being restricted to spouses, children or other financial dependants.
What about lump sum death benefits?
The 55% special lump sum tax charge has also been substantially revised in favour of recipients. This (much criticised) charge was previously payable on most forms of lump sum death benefit paid on death at or after age 75, as well as on lump sums paid from drawdown arrangements on death at any age.
From 6 April 2015, lump sum benefits paid from drawdown arrangements on death before age 75 will be free of income tax, if they are paid within the usual two year window. This brings such lump sums into line with lump sums payable from defined benefit arrangements or from uncrystallised money purchase funds.
Where the pension saver dies aged 75 or over, or where benefits from unused money purchase savings (drawdown or uncrystallised funds) are paid outside the two year limit, the special tax charge has been reduced to 45% for the 2015/16 tax year. These lump sums will be taxed at the recipient’s marginal rate from 6 April 2016 onwards, under changes included in the current Finance Bill.
The Bill will also remove the anomaly that a defined benefit lump sum death benefit which is paid outside the two year window is an unauthorised payment (rather than attracting the special tax charge). However, dependants’ pensions paid from a defined benefit arrangement will continue to be subject to income tax, regardless of the pension saver’s age at the date of death: an odd quirk.
And who are the losers?
The flipside of the above generosity comes in the form of fresh reductions to limits on tax-relieved savings. Already cut to £1.25m at the start of the 2014/15 tax year, the LTA will come down again to £1m from 6 April 2016. Longer term, the intention is that the LTA will be indexed by reference to increases in CPI from April 2018, and so should start to rise again. As yet, no draft legislation exists which incorporates these LTA changes.
The AA changes are more of a departure from the previous model. From 6 April 2015, there is a new £10,000 allowance for further money purchase savings, which applies where an individual has opted to access money purchase benefits through one of the new flexible options (flexi-access drawdown, UFPLS or the new flexible annuity contract, under which payment amounts may decrease), or in certain other scenarios. The new restricted allowance is an anti-avoidance measure, designed to curb income tax evasion through the use of salary sacrifice arrangements to contribute to a money purchase scheme, from which regular UFPLS (with a 25% tax free element) are then drawn as income. Any defined benefit savings are separately tested against the £30,000 balance of the standard allowance.
What’s happening to pensions tax relief for high earners?
The chancellor’s July Budget also announced the (widely anticipated) restriction of pensions tax relief for high earners, through the introduction of a tapered annual allowance from 6 April 2016. Tapering will kick in where an individual’s adjusted income, calculated before the deduction of member contributions and including the value of employer contributions, is at least £150,000. The standard allowance of £40,000 will be reduced by £1 for every £2 of income above the £150,000 threshold, down to a minimum allowance of £10,000 for those with adjusted income of £210,000 or above. It should be noted that the test relates to income, not just earnings, and therefore it may well be difficult for pension savers to predict whether or not they will be caught by the tapering provisions.
In order to make these new provisions operate properly, pension input periods (PIPs) – the reference periods against which compliance with the AA is tested – are to be aligned with the tax year from 6 April 2016, so that an individual’s pension savings are being assessed over the same period as his income. Although likely to be more straightforward in the longer term, in the short term this has resulted in some highly complex transitional provisions, under which the current tax year will effectively be split into two ‘mini’ tax years, with a combined AA of £80,000 (to avoid unfair treatment of those who saw the change coming and made additional pension contributions pre-Budget).
All open PIPs as at Budget day will automatically be treated as having closed on 8 July, and a new PIP will run for the balance of the current tax year, meaning that a saver may have two or even three PIPs for this tax year. Contributions in the pre-Budget PIP(s) will be tested against the whole of the £80,000 allowance. Contributions in the post-Budget PIP will be tested against the unused balance of the £80,000 carried forward from the pre-Budget ‘mini’ tax year, up to a maximum of £40,000. There are equivalent provisions relating to the new separate allowance of £10,000 for money purchase savings, which is likewise doubled to £20,000 for this tax year only. So some savers may get a sizeable (one-off) tax windfall for the 2015/16 tax year, depending on the distribution of their pension contributions pre- and post-8 July. To make calculations easier, any defined benefit pension savings during the tax year will simply be split pro rata between the two ‘mini’ tax years, even if the relevant benefits did not accrue evenly over the year.
The above changes relating to the AA are all to be found in the Finance Bill currently making its way through Parliament, and therefore may be subject to change in the finer detail, though it is unlikely that the underlying policy will change dramatically.
Will there be any protection for individual taxpayers?
As far as the LTA changes are concerned, the government has promised transitional protection for those who have already built up benefits above the £1m ceiling as at April 2016, similar to the various forms of protection introduced alongside previous changes to the LTA (primary protection, enhanced protection, fixed protection 2012 and 2014 and individual protection 2014). HMRC has floated the idea that there may not be a time limit for individuals to register for these protections, but full details are still awaited.
On the AA front, individuals whose income is £110,000 or less (before adding in the value of pension contributions) are not caught by the tapering provisions. However, there are anti-forestalling measures requiring any post-9 July 2015 salary sacrifice arrangements relating to pension contributions to be disregarded when applying this threshold test. Beyond this, there is no special protection. In particular, although carry forward of unused AA will continue to be available as present, the maximum carry forward from the current tax year will effectively be capped at the standard amount (£40,000), meaning that many savers will miss out on the full value of the doubled allowance.
What else is on the cards?
As if the foregoing changes were not enough for the industry to assimilate, the chancellor proceeded to throw the cat firmly among the pigeons with the announcement of a wide ranging review of the entire system of pensions tax relief, as set out in the Treasury’s paper, Strengthening the incentive to save: a consultation on pensions tax relief, issued on 8 July.
The paper invites views on how the current system of tax relief might be changed so as to encourage higher levels of pension saving, while still remaining fiscally sustainable over the longer term. Other than changes to the LTA and AA, the only reform option specifically mentioned is a change to a system of upfront taxation, where income tax is charged at the point contributions are placed into the pensions vehicle, rather than when pension benefits are ultimately drawn by the saver.
The potential implications for pension providers and savers of this shift from an ‘EET’ (i.e. exempt when invested, exempt during investment, taxed on exit) to a ‘TEE’ system would be huge. Ignoring all other considerations, what tax treatment would apply to benefits which have already been accrued under the EET system? The normal approach (of ring-fencing accrued benefits and continuing to administer them under the old tax system) would make an already complex system substantially more labyrinthine, as well as increasing the administrative burdens for providers.
Despite such concerns, some industry commentators have expressed fears that the immediate tax saving from the change will be impossible for the chancellor to resist, notwithstanding protestations from the Treasury and HMRC that this is a genuine consultation which is being approached by government with an open mind.
Other options have been trailed in discussions. A reform favoured by the former pensions minister, Steve Webb, would be the introduction of flat rate tax relief, set at a level above basic rate but below higher rate (thereby redistributing the available monetary incentive to those who need it most). Another possibility is to adopt the model used in Ireland of a stamp duty style tax on all pension savings (effectively, an ‘ETT’ approach), though this would sit oddly with the recently introduced charges cap for money purchase savings. Or the current system could be made more sustainable (i.e. affordable for the Treasury) by capping or removing the entitlement to tax-free cash.
Whatever the ultimate outcome of the consultation, pensions specialists are clearly living in interesting times.
Jeremy Goodwin (Eversheds) answers questions on recent developments in pensions taxation following the Budget and considers the current HM Treasury consultation.
Since George Osborne’s March 2014 Budget, the pension tax regime has seen some substantial changes, with further seismic shifts still under consideration in a HM Treasury consultation which runs until 30 September.
What changes have already been announced?
For pension lawyers, the new pension flexibilities introduced at the start of the current tax year were the headline news. These opened up drawdown to all money purchase pension savers, regardless of the size of their pension pot, and also allowed pension benefits from money purchase pots to be drawn purely as cash (the new uncrystallised funds pension lump sum or UFPLS). In both cases, the saver can benefit from the usual 25% tax-free cash amount. This can be taken upfront when using drawdown: if taking benefits as one or more UFPLS payments, 25% of each cash payment is tax free.
However, from a pure tax perspective, the key developments to date – in the sense of savers paying more (or less) tax – have been the recent changes to the treatment of death benefits, and to the lifetime allowance (LTA) and annual allowance (AA) regimes.
Who stands to gain from the changes?
The clear winners, in tax terms, are the recipients of death benefits. If unused money purchase pension savings (either uncrystallised funds or undrawn funds held in a flexi-access drawdown arrangement) are taken in the form of drawdown by the beneficiary, these are payable entirely free of income tax where the pension saver dies below age 75, provided that the beneficiary’s drawdown arrangement is set up within two years of the date when the scheme administrator first knows (or ought reasonably to have known) of the saver’s death.
If the pension saver is aged 75 or over at the date of death, or if the beneficiary’s drawdown arrangement is set up outside this two year window, the beneficiary’s drawdown income is taxable at his/her marginal rate. Unused funds can be passed on upon the beneficiary’s death, with the same tax rules applying (by reference to the beneficiary’s age at death). In a new departure, the pension saver or beneficiary can nominate the intended recipient, rather than payments being restricted to spouses, children or other financial dependants.
What about lump sum death benefits?
The 55% special lump sum tax charge has also been substantially revised in favour of recipients. This (much criticised) charge was previously payable on most forms of lump sum death benefit paid on death at or after age 75, as well as on lump sums paid from drawdown arrangements on death at any age.
From 6 April 2015, lump sum benefits paid from drawdown arrangements on death before age 75 will be free of income tax, if they are paid within the usual two year window. This brings such lump sums into line with lump sums payable from defined benefit arrangements or from uncrystallised money purchase funds.
Where the pension saver dies aged 75 or over, or where benefits from unused money purchase savings (drawdown or uncrystallised funds) are paid outside the two year limit, the special tax charge has been reduced to 45% for the 2015/16 tax year. These lump sums will be taxed at the recipient’s marginal rate from 6 April 2016 onwards, under changes included in the current Finance Bill.
The Bill will also remove the anomaly that a defined benefit lump sum death benefit which is paid outside the two year window is an unauthorised payment (rather than attracting the special tax charge). However, dependants’ pensions paid from a defined benefit arrangement will continue to be subject to income tax, regardless of the pension saver’s age at the date of death: an odd quirk.
And who are the losers?
The flipside of the above generosity comes in the form of fresh reductions to limits on tax-relieved savings. Already cut to £1.25m at the start of the 2014/15 tax year, the LTA will come down again to £1m from 6 April 2016. Longer term, the intention is that the LTA will be indexed by reference to increases in CPI from April 2018, and so should start to rise again. As yet, no draft legislation exists which incorporates these LTA changes.
The AA changes are more of a departure from the previous model. From 6 April 2015, there is a new £10,000 allowance for further money purchase savings, which applies where an individual has opted to access money purchase benefits through one of the new flexible options (flexi-access drawdown, UFPLS or the new flexible annuity contract, under which payment amounts may decrease), or in certain other scenarios. The new restricted allowance is an anti-avoidance measure, designed to curb income tax evasion through the use of salary sacrifice arrangements to contribute to a money purchase scheme, from which regular UFPLS (with a 25% tax free element) are then drawn as income. Any defined benefit savings are separately tested against the £30,000 balance of the standard allowance.
What’s happening to pensions tax relief for high earners?
The chancellor’s July Budget also announced the (widely anticipated) restriction of pensions tax relief for high earners, through the introduction of a tapered annual allowance from 6 April 2016. Tapering will kick in where an individual’s adjusted income, calculated before the deduction of member contributions and including the value of employer contributions, is at least £150,000. The standard allowance of £40,000 will be reduced by £1 for every £2 of income above the £150,000 threshold, down to a minimum allowance of £10,000 for those with adjusted income of £210,000 or above. It should be noted that the test relates to income, not just earnings, and therefore it may well be difficult for pension savers to predict whether or not they will be caught by the tapering provisions.
In order to make these new provisions operate properly, pension input periods (PIPs) – the reference periods against which compliance with the AA is tested – are to be aligned with the tax year from 6 April 2016, so that an individual’s pension savings are being assessed over the same period as his income. Although likely to be more straightforward in the longer term, in the short term this has resulted in some highly complex transitional provisions, under which the current tax year will effectively be split into two ‘mini’ tax years, with a combined AA of £80,000 (to avoid unfair treatment of those who saw the change coming and made additional pension contributions pre-Budget).
All open PIPs as at Budget day will automatically be treated as having closed on 8 July, and a new PIP will run for the balance of the current tax year, meaning that a saver may have two or even three PIPs for this tax year. Contributions in the pre-Budget PIP(s) will be tested against the whole of the £80,000 allowance. Contributions in the post-Budget PIP will be tested against the unused balance of the £80,000 carried forward from the pre-Budget ‘mini’ tax year, up to a maximum of £40,000. There are equivalent provisions relating to the new separate allowance of £10,000 for money purchase savings, which is likewise doubled to £20,000 for this tax year only. So some savers may get a sizeable (one-off) tax windfall for the 2015/16 tax year, depending on the distribution of their pension contributions pre- and post-8 July. To make calculations easier, any defined benefit pension savings during the tax year will simply be split pro rata between the two ‘mini’ tax years, even if the relevant benefits did not accrue evenly over the year.
The above changes relating to the AA are all to be found in the Finance Bill currently making its way through Parliament, and therefore may be subject to change in the finer detail, though it is unlikely that the underlying policy will change dramatically.
Will there be any protection for individual taxpayers?
As far as the LTA changes are concerned, the government has promised transitional protection for those who have already built up benefits above the £1m ceiling as at April 2016, similar to the various forms of protection introduced alongside previous changes to the LTA (primary protection, enhanced protection, fixed protection 2012 and 2014 and individual protection 2014). HMRC has floated the idea that there may not be a time limit for individuals to register for these protections, but full details are still awaited.
On the AA front, individuals whose income is £110,000 or less (before adding in the value of pension contributions) are not caught by the tapering provisions. However, there are anti-forestalling measures requiring any post-9 July 2015 salary sacrifice arrangements relating to pension contributions to be disregarded when applying this threshold test. Beyond this, there is no special protection. In particular, although carry forward of unused AA will continue to be available as present, the maximum carry forward from the current tax year will effectively be capped at the standard amount (£40,000), meaning that many savers will miss out on the full value of the doubled allowance.
What else is on the cards?
As if the foregoing changes were not enough for the industry to assimilate, the chancellor proceeded to throw the cat firmly among the pigeons with the announcement of a wide ranging review of the entire system of pensions tax relief, as set out in the Treasury’s paper, Strengthening the incentive to save: a consultation on pensions tax relief, issued on 8 July.
The paper invites views on how the current system of tax relief might be changed so as to encourage higher levels of pension saving, while still remaining fiscally sustainable over the longer term. Other than changes to the LTA and AA, the only reform option specifically mentioned is a change to a system of upfront taxation, where income tax is charged at the point contributions are placed into the pensions vehicle, rather than when pension benefits are ultimately drawn by the saver.
The potential implications for pension providers and savers of this shift from an ‘EET’ (i.e. exempt when invested, exempt during investment, taxed on exit) to a ‘TEE’ system would be huge. Ignoring all other considerations, what tax treatment would apply to benefits which have already been accrued under the EET system? The normal approach (of ring-fencing accrued benefits and continuing to administer them under the old tax system) would make an already complex system substantially more labyrinthine, as well as increasing the administrative burdens for providers.
Despite such concerns, some industry commentators have expressed fears that the immediate tax saving from the change will be impossible for the chancellor to resist, notwithstanding protestations from the Treasury and HMRC that this is a genuine consultation which is being approached by government with an open mind.
Other options have been trailed in discussions. A reform favoured by the former pensions minister, Steve Webb, would be the introduction of flat rate tax relief, set at a level above basic rate but below higher rate (thereby redistributing the available monetary incentive to those who need it most). Another possibility is to adopt the model used in Ireland of a stamp duty style tax on all pension savings (effectively, an ‘ETT’ approach), though this would sit oddly with the recently introduced charges cap for money purchase savings. Or the current system could be made more sustainable (i.e. affordable for the Treasury) by capping or removing the entitlement to tax-free cash.
Whatever the ultimate outcome of the consultation, pensions specialists are clearly living in interesting times.
Budget, the pension tax regime has seen some substantial changes, with further seismic shifts still under consideration in a HM Treasury consultation which runs until 30 September.
