Pensions tax relief

This article was first published in the October 2011 edition of Accounting and Business magazine.

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Previously, different rules applied to each type of pension 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 from April 2011 tax relief on pension savings was going to be restricted to the basic rate of 20% for high income individuals. The new Coalition Government agreed that a reform of pensions tax relief was a necessary part of reducing the fiscal deficit, but has taken an entirely different approach.

Annual allowance

The annual allowance for 2010-11 was GBP255,000, and this was due to remain unchanged until 2015-16. For 2011-12 the Coalition Government has reduced the annual allowance to GBP50,000. However, pension savings made within this limit continue to qualify for tax relief at a person's highest marginal rate of tax, be it the basic rate of 20%, the higher rate of 40%, or the additional rate of 50%.

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 have been introduced to 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 the three years 2008-09, 2009-10 and 2010-11 in order to ascertain any brought forward figure. For example, a person has made pension savings of GBP42,000 for 2008-09, GBP38,000 for 2009-10, but was not a member of a pension scheme for 2010-11. For 2011-12 the brought forward figure is GBP20,000 (GBP8,000 (GBP50,000 - GBP42,000) + GBP12,000 (GBP50,000 - GBP38,000)), and it is therefore possible to make pension savings of up to GBP70,000 (GBP50,000 + GBP20,000) 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 2011-12, the unused amount carried forward to 2012-13 would be GBP12,000. The annual allowance for 2011-12 is fully used, with the balance of GBP4,000 utilising some of the unused allowance for 2008-09. Therefore, just the unused allowance of GBP12,000 for 2009-10 is carried forward.

People who regularly make high pension savings but then for whatever reason are not a member of a pension scheme for a particular year, might decide to contribute a minimum amount in order to preserve the carry forward. If, in the above example, a minimum contribution of, say, GBP100, was paid for 2010-11 then an additional GBP49,900 (GBP50,000 - GBP100) of unused relief would be carried forward to 2011-12 and then further carried forward to 2012-13.

Pension input periods

There is no change to the complex rules for pension input periods, and the rules are now likely to be 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 2011-12 the relevant input period is that ending on 30 November 2011, and pension savings made during this period will be used to determine if the annual allowance for 2011-12 has been exceeded. However, it is the pension savings actually paid during the tax year (6 April 2011 to 5 April 2012) that will be used in calculating the tax liability for 2011-12.

It is possible to change a pension input period provided the new period is not longer than 12 months, and as long as the new period does not end in the same tax year as the previous period. Such a change can be used to double the amount of pension savings qualifying for tax relief in a particular tax year. For example, a person makes a pension contribution of GBP50,000 on 1 December 2011.

The pension input period would normally run for the following 12 months to 30 November 2012, but can be changed to, say, 31 December 2011. The second input period will then run from 1 January 2012 to 31 December 2012. A further pension contribution of GBP50,000 can then be paid during the period 1 January 2012 to 5 April 2012. Both contributions are paid during 2011-12, and will therefore qualify for tax relief in that year. However, for annual allowance purposes the first contribution falls into 2011-12 whilst the second falls into 2012-13 as that pension input period will end on 30 November 2012.

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% into his employer's defined contribution scheme. The employer contributes a further 6%. The pension savings are GBP20,000 (GBP200,000 x 10%) 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. From 6 April 2011 a standard valuation factor of 16 is used in these calculations rather than the previous factor of 10.

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 2011. On 1 January 2011 the employee's salary was GBP100,000 and she had 20 years of service. By 31 December 2011 her salary had increased to GBP106,000. The 12 month increase in the Consumer Price Index for September 2010 is 3.1%. The calculation is as follows:

For 2011-12 the employee's pension savings for annual allowance purposes are therefore GBP43,734. 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 2008-09, 2009-10 or 2010-11, any pension savings for those years in a defined benefit scheme must be calculated using the new valuation rules that apply from 6 April 2011.

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 the annual allowance tax charge. Previously, this charge was at a flat rate of 40%, but from 2011-12 onwards it is at a person's marginal rate of income tax.

For example, for 2011-12 a self-employed person has taxable income of GBP210,000. She paid gross personal pension contributions of GBP64,000 in respect of the pension input period ending on 5 April 2012, and no brought forward relief is available. The higher rate band will be increased to GBP214,000 (GBP150,000 + GBP64,000), so the surplus amount is GBP14,000 (GBP64,000 - GBP50,000).

GBP4,000 (GBP214,000 - GBP210,000) of this is taxed at the higher rate of 40%, with the remainder taxed at the additional rate of 50%. Therefore the annual allowance tax charge will be GBP6,600 ((GBP4,000 at 40%) + (GBP10,000 at 50%)).

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 one-off personal pension contribution may result in tax relief of 50% in 2011-12 (the year of payment), but the surplus amount may only be taxed at 40% in 2012-13 (the year in which the pension input period ends). With the previous flat rate of 40% this mismatch did not occur.

The complicated pension input period rules mean that with the reduced annual allowance 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 is currently GBP1,800,000. 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.

From 6 April 2012 the lifetime allowance will be reduced to GBP1,500,000, but it will be possible to protect existing pension savings of up to GBP1,800,000 from the effects of the reduction.

Transitional rules

The new rules that apply from 6 April 2011 were announced on 14 October 2010. It is possible that a person has pension savings prior to that date but which relate to a pension input period ending in 2011-12, and so be subject to the reduced annual allowance of GBP50,000.

Therefore, where a pension input period started before 14 October 2010 but ends in 2011-12, an annual allowance of GBP255,000 will be used to determine whether a tax charge arises. However, the GBP50,000 limit will still apply for any pension savings made during the period from 14 October 2010 to the end of pension input period.

Conclusion

The Coalition Government has estimated that the reduced GBP50,000 annual allowance will only affect 100,000 people. The change does not affect anybody with annual pension savings of less than GBP50,000 regardless of their level of income. Whether people are better or worse off when compared to the previous Labour Government's proposed changes will depend on their level of income and their amount of pension savings.

A person with net income of GBP400,000 and annual pension savings of GBP50,000 is better off. Under the Labour Government proposals tax relief would have been restricted to GBP10,000 (GBP50,000 at 20%), but relief is now GBP25,000 (GBP50,000 at 50%). However, if the annual pension savings were instead GBP200,000 the person is worse off. Tax relief is still only GBP25,000, but under the Labour Government proposals tax relief would have been GBP40,000 (GBP200,000 at 20%).