A brand-new regime for UK pensions was introduced on 6 April 2006 (‘A-Day’). On 22 April 2009 the Government introduced new legislation to restrict higher rate tax relief on pension contributions for high earners. This was intended to come into effect in two stages, as follows:

With immediate effect from 22 April 2009 a new two-tier system of tax relief for pension contribution’s was introduced that treated individuals with ‘relevant income’ of £150,000 or greater, far worse than those with lower income. The £150,000 ‘relevant income’ threshold was then reduced to £130,000 on 9 December 2009.

The second stage was due to come into effect on 6 April 2011. This phase would have been extremely complicated and was widely condemned for its complexity by the pension community.

Following the change in government earlier this year, the new coalition government announced that it would repeal the complex provisions that were due to take effect from 6 April 2011 and would consult on an alternative approach that would generate annual savings of around £4bn, similar to the previous Government’s plans. The results of that consultation were published on 14 October 2010.

The Government’s proposals

The main changes announced by the Government on 14 October 2010 are set out below:

A. ANNUAL ALLOWANCE

• From 6 April 2011 the Annual Allowance for tax relief on pension savings will be £50,000 (reduced from £255,000 in 2010/11). There is no proposal to index the level of the Annual Allowance between now and 5 April 2016. However, the Government will consider indexing it after that date.

• Tax relief on personal pension contributions will continue to be available at individual’s marginal tax rate (and will not be restricted for high earners as planned by the previous Government).

• For the purpose of applying the new rules to final salary schemes, each year’s increase in accrued benefits will be multiplied by a flat factor of 16. Also, for the purpose of valuing the increase in the accrued benefits, the accrued benefits at the beginning of the year will, from 6 April 2011, be increased in line with the Consumer Price Index.

• The existing blanket exemption from the Annual Allowance in the year benefits are taken will be removed from 6 April 2011. However, the Annual Allowance test will continue not to be applied in the year of death and, from 6 April 2011 will not be applied in cases of serious (terminal) ill-health. Furthermore, the Government will look to exempt ill-health benefits from the Annual Allowance test but no exemptions will be applied in cases of redundancy

• A new three year carry forward rule will be introduced that allows individuals to carry forward any unused Annual Allowance from the last three tax years (but only if they have made some pension savings in those years). Carry forward will be available against an assumed Annual Allowance of £50,000 for the tax years 2008/09, 2009/10 and 2010/11.

There is a strict order in which an individual can use up their Annual Allowance. The Annual Allowance in the current tax year must be used first, followed by the unused Annual Allowances from the three earlier years, using the earliest tax year first (but if no pension savings have been made for an earlier year then there will be no Annual Allowance for that year to carry forward).

• Pension Input Periods (PIPs) will not be compulsorily aligned with the tax year and transitional rules for PIPs will be introduced on 14 October 2010 (taking immediate effect) for those whose PIP for 2011-12 has already started.

B. LIFETIME ALLOWANCE

• From 6 April 2012 the Lifetime Allowance for “tax-privileged” pension saving will be reduced from its current level of £1.8m to £1.5m, the level that it was at A-Day. There do not appear to be any plans to increase this figure.

• A protection regime will be developed to ensure that individuals whose pension entitlements are currently in excess of £1.5m have that excess protected from any tax charge (subject to a cap at the level of the existing Lifetime Allowance of £1.8m).

• If an individual’s benefits exceed the Lifetime Allowance then the tax charges that apply to the excess benefits over the Lifetime Allowance will remain unchanged (55 per cent if paid as a lump sum and 25 per cent if paid from annual pension income, on top of marginal rate tax on the pension income).

• The maximum tax-free lump sum will remain at 25 per cent of the Lifetime Allowance.

• From 6 April 2012 the trivial commutation limit will be de-linked from the Lifetime Allowance (where it is currently set at 1 per cent of the Lifetime Allowance). It will remain at its current level of £18,000.

• The Government will bring forward legislation that will ensure that employer-financed retirement benefit schemes (EFRBS) are no more attractive than other forms of remuneration. This is to address the use of these intermediary vehicles to disguise remuneration and avoid, reduce or defer payment of tax.

Comments

These changes represent a massive cutback to the enhanced tax reliefs introduced on A Day, a little over four years ago. However, the financial state of the economy is now very different so there is little surprise in seeing the Government back-track on the A-Day position. Furthermore, these proposals have been trailed in advance and they represent a tremendous improvement over the hideously complex changes that were planned by the previous Government.

The new Annual Allowance of £50,000 is somewhat higher than had previously been suggested by the Government but it seems that this has been facilitated by reducing the Lifetime Allowance from £1.8m to £1.5m.

The new three year carry forward rule is a particularly welcome change and represents a reversal of the existing use it or lose it rule that applies to the Annual Allowance. This is particularly helpful for those individuals who have variable income and find it difficult to plan their pension contributions.

Whilst the new proposals are very good news for personal pensions, when compared with the previous Governments plans, they will undoubtedly create serious problems for final salary schemes where high earners could unwittingly find that a significant salary increase for an individual has the result of the breaching the Annual Allowance test, thereby resulting in high tax charges on that individual.

Maximum contributions that can be paid during the current tax year

One significant side effect of all the changes and announcements discussed above is that there is now considerable confusion about the maximum contributions that can be paid during the current tax year (to 5 April 2011) and the following notes are intended to clarify the position. Note that this is just a summary of the position and should not be considered to be a complete or definitive statement of the situation.

There are no restrictions on the contributions that may be made to registered pension schemes (whether by individuals or their employers) but there are four main restrictions that apply to the tax relief available on these contributions, as follows:

(1) Tax relief will be available on an individual’s personal contributions to all registered pension schemes in any tax year up to 100% of their ‘relevant UK earnings’ (or £3,600 if greater or if they have no ‘relevant UK earnings’).

(2) An employer’s pension contributions will normally be allowable for corporation tax relief subject to the employer’s Inspector of Taxes being satisfied that they are ‘wholly and exclusively’ for the purposes of its trade – see Section BIM46000 onwards of the HMRC Business Income Manual for further details.

(3) Annual Allowance: If the total of an individual’s personal contributions plus those from their employer to all registered pension schemes in any PIP exceeds the Annual Allowance that applies to the tax year in which the PIP ends(the Annual Allowance is £255,000 for the current tax year) then the excess will be subject to a 40% Annual Allowance Charge.

PIPs are a strange and potentially complex concept. A PIP is usually the same as the tax year but there are circumstances where it is the year commencing on the anniversary of the date on which the first contribution was made to the pension scheme in question. Furthermore, it is possible for an individual to choose to end a PIP early, although there can be only one PIP during a tax year.

Therefore, it is possible to for pension contributions of up to £255,000 to be paid in the current tax year without incurring the Annual Allowance Charge as long as the individual’s Pension Input Period ends before 6 April 2011 (since the Annual Allowance will be reduced to £50,000 for the 2011/12 tax year).

(4) Special Annual Allowance (SAA): Additional restrictions on pensions tax relief apply to individuals who have ‘relevant income’ of £130,000 pa or more in the current tax year or in either of the two previous tax years. These ‘high earners’ will be subject to a 20% tax charge, the SAA Charge, on the amount by which their total pension contributions, including any paid for them by their employer, in the current tax year exceed their SAA.

The SAA is normally £20,000 but it will be increased for those individuals where the annual average of the total pension contributions paid for them less frequently than quarterly during the previous three tax years exceeds £20,000. In these cases the SAA will be the annual average of those contributions up to a maximum of £30,000. Furthermore, some pension contributions are protected and do not need to be tested against the SAA.

To summarise, this means that it is still possible (subject to conditions) for pension contributions of up to £255,000 to be paid for an individual in the current tax year as long as the individual does not count as a high earner as per (4) above.

When considering the content of this briefing paper please bear in mind that some of the content is based on draft legislation and may be subject to change. The content should therefore be considered for information only and no action or indeed inaction should be taken without taking advice.

If you wish to discuss how these changes to pension legislation may affect your pension provision then please contact Eric Norman Walker enormanwalker@menzieswm.co.uk or your Financial Planning Manager.

Menzies Wealth Management Limited is authorised and regulated by the Financial Services Authority and is registered in England and Wales under registered number 06597008 with registered office at 1st Floor, Midas House, Goldsworth Road, Woking, Surrey GU21 6LQ.