Pensions tax relief (UK Finance Act 2013)

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In April 2006 the pension scheme rules were simplified, with the same rules applying to both personal pension and occupational pension schemes. Previously, different rules applied to each type of scheme, with the rules for personal pension scheme savings being particularly complicated. The amount of tax relief depended on a person's age and earnings, and there was a six year carry forward of unused relief. Under the simplified rules any amount can be contributed into a pension scheme, with tax relief effectively being restricted to the lower of earnings and an annual allowance. The changes meant that people could contribute significantly more towards their retirement.

It was too good to last. After just three years the Labour Government announced that tax relief on pension savings was going to be restricted to the basic rate of 20 percent for high income individuals. The Coalition Government agreed that a reform of pensions tax relief was a necessary part of reducing the fiscal deficit, but have taken an entirely different approach

Annual allowance

The annual allowance for 2010-11 was GBP255,000, but for 2011-12 the Coalition Government reduced it to GBP50,000. The annual allowance has remained unchanged at GBP50,000 for 2012-13 and 2013-14, but will be further reduced to GBP40,000 from 2014-15 onwards. However, pension savings made within the GBP50,000 limit continue to qualify for tax relief at a person's highest marginal rate of tax, be it the basic rate of 20 percent, the higher rate of 40 percent, or the additional rate of 45 percent.

If the annual allowance is not fully used in any tax year then it is now possible to carry forward any unused allowance for up to three years. However, carry forward is only possible if a person is a member of a pension scheme for a particular tax year. Therefore for any year in which a person is not a member of a pension scheme the annual allowance is lost. The carry forward rules protect people, especially employees, who exceed the GBP50,000 annual limit due to a one-off 'spike' in pension savings.

Even though the new pension rules only apply from 2011-12, a notional GBP50,000 limit is used for years prior to this in order to ascertain any brought forward figure. For example, a person has made pension savings of GBP42,000 for 2010-11, GBP38,000 for 2011-12, and GBP32,000 for 2012-13. For 2013-14 the brought forward figure is GBP38,000 (GBP8,000 (GBP50,000 - GBP42,000) + GBP12,000 (GBP50,000 - GBP38,000) + GBP18,000 (GBP50,000 - GBP32,000)), and it is therefore possible to make pension savings of up to GBP88,000 (GBP50,000 + GBP38,000) for this year as long as he or she has sufficient income to benefit from the relief.

The annual allowance for the current tax year is utilised first, and then any unused allowances from earlier years with those from the earliest year used first. Therefore, if in the above example pension savings of GBP54,000 were made for 2013-14, the unused amount carried forward to 2014-15 would be GBP30,000. The annual allowance for 2013-14 is fully used, with the balance of GBP4,000 utilising some of the unused allowance for 2010-11. Therefore, the unused allowances of GBP12,000 for 2011-12 and GBP18,000 for 2012-13 are carried forward. When the annual allowance is reduced to GBP40,000 from 2014-15 onwards, the carry forward from 2011-12, 2012-13 and 2013-14 will be based on the current GBP50,000 limit.

Pension input periods

In many cases, there is no change to the complex pre-6 April 2011 pension input period rules, and these rules are now far more relevant with a reduced annual allowance of GBP50,000.

The annual allowance is not measured against pension savings actually paid in a tax year, but is instead measured against the savings for a pension input period. These are normally 12 months long. A person may have more than one pension input period if they have several different pension arrangements. It is the pension input period ending within the tax year that is relevant. For example, a person's pension scheme has an input period that ends on 30 November. For the tax year 2013-14 the relevant input period is that ending on 30 November 2013, and pension savings made during this period will be used to determine if the annual allowance for 2013-14 has been exceeded. However, it is the pension savings actually paid during the tax year (6 April 2013 to 5 April 2014) that will be used in calculating the tax liability for 2013-14. For pension schemes commencing on or after 6 April 2011, the first pension input period by default ends on 5 April. So if a person makes a pension contribution on 1 December 2013, the first pension input period will run from 1 December 2013 to 5 April 2014. Future periods are then aligned with tax years. The default date of 5 April applies unless an earlier or later date is nominated. It is possible to change a subsequent pension input period provided the new period ends in the tax year following the tax year in which the previous period ended.

It is sometimes possible to manipulate pension input periods to increase the amount of pension savings qualifying for tax relief in a particular tax year. For example, a person makes a personal pension contribution of GBP50,000 on 1 December 2013, nominating a pension input period ending on 31 December 2013. The second input period will run from 1 January 2014 to 31 December 2014. A further pension contribution of GBP40,000 (the amount of annual allowance for 2014-15) can then be paid during the period 1 January 2014 to 5 April 2014. Both contributions are paid during 2013-14, and will therefore qualify for tax relief in that year. However, for annual allowance purposes the first contribution falls into 2013-14 whilst the second falls into 2014-15.

Pension savings

For personal pensions and other defined contribution schemes the amount of pension saving for a particular pension input period is simply the gross amounts paid during that period, including any contribution from an employer. For example, an employee with a salary of GBP200,000 contributes 4 percent into his employer's defined contribution scheme. The employer contributes a further 6 percent. The pension savings are GBP20,000 (GBP200,000 x 10 percent) for each period.

For defined benefit schemes the rules are more complex. For a particular pension input period the amount of pension saving is found by comparing the notional capital value of the pension at the end of the period to what it was at the start of the period. A standard valuation factor of 16 is used in these calculations. The opening capital value is increased by the 12 month increase in the Consumer Price Index for the September prior to the tax year. The increase in value over the period is the amount of pension savings for that period.

For example, an employee is a member of a final salary scheme that will provide her with a pension of 1/60th of salary for each year of service. The pension input period is the 12 months to 31 December 2013. On 1 January 2013 the employee's salary was GBP100,000 and she had 20 years of service. By 31 December 2013 her salary had increased to GBP106,000. The 12 month increase in the Consumer Price Index for September 2012 is 2.2 percent. The calculation is as follows:

For 2013-14 the employee’s pension savings for annual allowance purposes are therefore GBP48,534. This is much higher than the employee’s actual contributions (probably in the region of GBP6,500) qualifying for tax relief.

When calculating the amount of unused annual allowance from 2010-11, any pension savings for this year in a defined benefit scheme must be calculated using the current valuation rules.

Annual allowance tax charge

Where pension savings are made in excess of the annual allowance (including any brought forward amount), then the surplus amount is subject to an annual allowance tax charge. This charge is at a person’s marginal rate of income tax.

For example, for 2013-14 a self-employed person has taxable income of GBP210,000. She paid gross personal pension contributions of GBP64,000 in respect of her pension input period ending on 5 April 2014, and no brought forward relief is available - so the surplus amount is GBP14,000 (GBP64,000 - GBP50,000). The higher rate band will be increased to GBP214,000 (GBP150,000 + GBP64,000), so GBP4,000 (GBP214,000 - GBP210,000) of the surplus amount is taxed at the higher rate of 40 percent, with the remainder taxed at the additional rate of 45 percent. Therefore the annual allowance tax charge will be GBP6,100 ((GBP4,000 at 40 percent) + (GBP10,000 at 45 percent)).

In this example the net effect is to remove the tax relief that should not have been given. However, because of the way in which pension input periods work, there may be a mismatch between the tax relief given on pension savings and the amount of relief subsequently removed by the annual allowance tax charge. For example, a pension contribution may result in tax relief of 45 percent in 2013-14 (if this is the year of payment), but the surplus amount may only be taxed at 40 percent in 2014-15 (if this is the year in which the pension input period ends).

The complicated pension input period rules mean that with an annual allowance of just GBP50,000 (and soon to be GBP40,000) it will be very easy for a person to inadvertently incur an annual allowance tax charge, especially where an employee changes employments. It may therefore be advisable where possible for a person to align their input period(s) with the tax year.

Lifetime limit

The lifetime allowance for 2013-14 is GBP1,500,000, and will be reduced to GBP1,250,000 from 2014-15 onwards. This allowance applies to the total funds that can be built up within a person’s pension arrangements, and there will be a tax charge when that person subsequently withdraws the funds in the form of a pension if the limit is exceeded.

Conclusion

The Government has estimated that the latest reduction in the level of annual allowance to GBP40,000 will affect around 140,000 people. The lower level of annual allowance that has applied since 6 April 2011 does not affect anybody with annual pension savings below the limit regardless of their level of income.