Pensions Tax Relief – Reduced Annual Allowance from 6th April 2011

December 3rd, 2010

December 2010: One of the major changes announced by the previous Labour Government was the intention to restrict the availability of higher rate tax relief on pension savings made to registered pension schemes with effect from 6 April 2011, for high earners with gross taxable income of £150,000, or more. The effect of this would have meant that the annual allowance of £255,000 would have remained unchanged, but the availability of higher rate tax relief for high earners would have gradually been withdrawn for those with gross income between £150,000 and £180,000, with no higher rate relief being available at all if gross income exceeded £180,000.

However, on 14 October 2010, the new Coalition Government announced that it was scrapping this planned change, and that in its place from 6 April 2011, there will now simply be a reduced annual allowance of £50,000 for everyone, regardless of their level of income.

The current ‘special’ annual allowance rules that might affect you if you have total taxable income of £130,000, or more, will also cease to apply from 6 April 2011.

What is the annual allowance?

The annual allowance (AA) effectively places an annual limit on the total amount of tax efficient ‘pension savings’ that can be made to registered pension schemes (occupational and personal).

Since its introduction in 2006/07, when the initial annual allowance was £215,000, the annual allowance has increased by £10,000 each tax year, but from 2011/12 it will be reduced to £50,000 and remain frozen at this level until at least 2015/16.

This means that from 2011/12, if the total contributions to all registered money purchase schemes made by, or on behalf of an individual (including by an employer), when aggregated with the increase in the capital value of any benefits held under a final salary scheme exceeds this annual limit, the individual will be subject to a tax charge on the excess (see below for details of the carry forward facility that will be introduced from 2011/12).

How are final salary scheme members affected?

When valuing the increase in value for active members of a final salary scheme, the current conversion factor of £10 capital for each £1 of accrued pension will be replaced by a higher flat rate factor of 16:1.

This represents a significant increase, although to soften the blow the “opening value” of an individual’s final salary scheme rights will first be revalued in line with inflation (CPI) for the purposes of this test – thus meaning that only accrued pension above this amount will actually count towards the annual allowance.

So, for example, if at the start of a tax year, a member of a final salary scheme has accrued pension rights of £12,500 pa (after allowing for indexation) but by the end of that tax year, after receiving a pay rise and accruing an additional years service this has risen to £16,000 pa –  the difference of £3,500 based on the valuation factor of 16:1 has a capital value of £56,000, and therefore exceeds the annual allowance for 2011/12 by £6,000.

If the member has no ‘unused’ annual allowance to carry forward from a previous tax year to offset against this £6,000 excess, as a 40% higher rate taxpayer, the tax charge would therefore be £6,000 x 40% = £2,400.

What changes are being made to the tax charge and how will it be paid?

The tax charge is currently set at a flat rate of 40% but from 6 April 2011 this will be replaced by a tailored tax charge of up to 50% in order to cancel-out any tax relief on any excess pension savings made above the annual allowance.

Like now, any tax charge will be met by individuals out of their current income, via self-assessment, although the Government has said that where the charge is above a certain level that is not manageable out of current income (this level is not currently specified), there should be the option to spread the tax charge over a number of years or allow the member’s pension scheme to pay the charge on their behalf.

Carry Forward

It is important to remember that it will be possible to carry-forward any ‘unused’ annual allowance from up to three previous tax years to offset against any pension savings amount in excess of the £50,000 annual allowance before a tax charge applies – but only if the individual was a member of a registered pension scheme at some point in the tax year that the unused annual allowance is being carried forward from.

So, if despite being a member of a registered pension scheme for a number of years no pension savings are made by or on behalf of an individual for 3 years in a row, a pension input amount of £200,000 could be made in the 4th year without incurring a tax charge!

Action Points

Speak to your adviser if you think you might be caught out by the new, significantly reduced AA of £50,000. This is most likely to impact on higher earning members of money purchase schemes who benefit from employer contributions and higher earning members of final salary schemes.

The fact that the valuation factor for active members of final salary schemes is rising from 10:1 to 16:1 means that an increase in scheme pension rights of over £3,000 between the start and end of the schemes ‘pension input period’ will leave little or no scope to make any additional money purchase contributions without incurring a tax charge (unless there is some unused AA to carry forward from previous years).

Higher earners in particular may also want to speak to their employer regarding the option of capping pensionable salary increases (i.e. so only part of any pay increase is actually pensionable) in which case it may be possible to negotiate a higher pay increase to compensate for the fact that not all of it is pensionable.

Ensure that you have records of the amount of pension savings being made by you, and on your behalf, so you can calculate what scope you have (if any) for making additional contributions. In some cases, it might be necessary for the total amount of pension savings to be reduced.

If you are not caught by the ‘special’ annual allowance, speak to your adviser about the opportunities to maximise pension savings to schemes whilst the AA for the current 2010/11 tax year remains at £255,000.  It should be noted, however, that if you are already a member of a scheme that has a ‘pension input period’ that will end in 2011/12, and the ‘end date’ cannot be brought forward to end in this tax year, any pension savings made on or after 14 October 2010 that exceeds £50,000, will give rise to a tax charge to the extent that any excess cannot be reduced or eliminated by carrying forward an ‘unused’ AA from a previous tax year.  This is a potentially complicated area so advice should definitely be sought from your adviser if you think you could be affected.

You may wish to consider maximising contributions to tax-free ISAs because these do not count towards the annual allowance. And remember, from 6 April 2011/12, the overall ISA contribution limits is going up to £10,680, of which £5,340 can be paid into a cash ISA.