New rules in relation to pensions came into force on 6 April 2006, commonly referred to as A-Day . The changes affected everyone involved in pension planning and were introduced in the name of simplification.
Essentially, the changes unified the existing pensions legislation at the time to create a new basis for the operation of all pension arrangements. For some, this meant improvements in their position, but for others there were further restrictions and, potentially, additional tax liabilities.
Individuals will be eligible for relief at their marginal rate of tax on contributions into pension schemes. This relief will be available on contributions of up to 100% of the individual’s annual earnings or £3,600 (if greater). For higher earners, tax relief will only be available for contributions up to the annual allowance – this has been set at £215,000 for the 2006/07 tax year.
The annual allowance represents the total level of contributions to the fund. This includes amounts paid by the individual and their employer and the increase in value of benefits from a final salary scheme. Where an employer’s contribution into an individual’s pension fund exceeds the annual allowance, the individual will pay tax at 40% on the excess. In addition, there will be no tax relief available for any personal contributions made over the annual allowance.
While there will be no limit on the amount that an employer can contribute into an employee’s pension fund, contributions will need to be “wholly and exclusively for the benefit of the business” to qualify for corporation tax relief. Additionally, if HM Revenue & Customs (HMRC) deem a relatively large contribution to be inappropriate, they may withhold tax relief for the employer. Little clear guidance has been issued on this issue at the present time.
There will be an effective limit on the maximum benefits available from a pension fund. Referred to as the lifetime allowance, this has been set at £1.5 million for 2006/07 and increases have been announced by the Chancellor up to 2010. The lifetime allowance applies to pension benefits when they are being taken (referred to as crystallisation) but will take account of benefits already in force or in payment.
Benefits that exceed the lifetime allowance will be subject to a lifetime allowance charge (LAC) of 25%. This will be payable directly from the fund at retirement. Where benefits are subject to this charge they can be taken as a taxed lump sum. Such a lump sum would be taxed at 40% (after the 25% already paid by the fund) and therefore the total tax charge would be 55%.
Individuals who have large existing funds at A-Day and are likely to be affected by the lifetime allowance can opt for primary protection. This increases the value of their lifetime allowance to the level of their total fund value at A-Day . This will provide protection against the LAC but it could still apply to the benefits derived from future contributions or high levels of fund growth.
Alternatively, enhanced protection offers the individual protection from all future LACs, regardless of the size of their fund or future rates of growth. However, this protection comes at a price – no further benefits can be accrued into the fund after A-Day .
Under the new rules, individuals will be able to take pension benefits and continue to work, which is only possible at present under certain types of pension arrangement. In addition the earliest retirement age will become 50 at A-Day but increasing to 55 from April 2010.
On death before retirement, the pension fund can be paid as a tax-free lump sum, subject to the lifetime allowance. Death benefits above the lifetime allowance will either be taxable at a rate of 55% or paid as a dependant’s pension.
Under the new legislation, the pension scheme earnings cap is abolished. The earnings cap set the ceiling for contributions that could be paid to, and the benefits that could be paid by, a tax-approved pension fund. The removal of this cap could have implications for defined benefit (final salary) pension schemes, as many of the scheme rules set the benefits payable by reference to the earnings cap. Employment contracts and pension scheme rules may need to be rewritten to minimise the additional liabilities that could arise.
The maximum tax-free cash lump sum available at retirement is to be set at 25% of the fund (up to the lifetime allowance – ie the maximum under the current limits will be £375,000). Transitional protection will allow existing rights to tax-free cash above the 25% limit to be retained if they are from an occupational pension scheme. In order to secure this advantage, the individual must remain a member of the occupational scheme until retirement – although there are certain exceptions where a scheme winds up or where the benefits are part of a bulk transfer.
There will be two main bases for taking income on retirement. Secured income is a guaranteed pension, provided by an insurance company or scheme, and is similar to the annuity arrangements that are currently available. This will have the added ability to provide for limited lump sum benefits on death after retirement but before age 75.
Unsecured income is similar to the current income drawdown arrangements, which allow a pension fund to continue post-retirement with the income being drawn directly from the fund. This allows the fund to be paid (less any surcharge and tax) on death before the age of 75. The level of income withdrawn will be limited to rates laid down by the Government Actuaries Department but there is no minimum.
A new type of pension, know as the alternative secured pension (ASP) will be available at age 75 to allow a form of continued drawdown at that age. If the individual dies while taking ASP, the fund must first be used to provide a dependant’s income but thereafter can be transferred into the pension fund of another nominated scheme member. This will enable pension funds to be passed down the family in future.
The Government have indicated that inheritance tax (IHT) will be charged on such transfers and this will be deducted from the fund. In addition, they have warned that the initial reason for these rules was to cater for people with a religious objection to annuities and they will be further examining the use of this option.
If an individual dies before retirement, their pension fund can be paid as a tax-free cash lump sum, subject to the lifetime allowance. Benefits above that level will either be taxable at 55% or paid as a dependant’s pension.
The assets available for pension funds to invest in are to be equalised, with an increased range of asset classes being allowable (although residential property and assets which can be used by the member will be restricted).
There is also an anomaly in respect of unlisted equities. An occupational scheme will only be able to invest up to 5% of its assets in the shares of an unlisted or sponsoring company but there is no such limit for personal pension arrangements.
The ability of a pension fund to borrow to make a purchase (eg of a commercial property) is to be limited to 50% of the fund value. In most cases this will represent a significant reduction in the amount that can be borrowed (eg under the pre A-Day rules, some pension funds could borrow up to 75% of the value of the property).
Funded Unapproved Retirement Benefit Scheme (FURBS)
Existing FURBS will continue to operate under the present rules but contributions made after 6 April 2006 will be subject to the following rules:
- no tax charge will arise on the employee when the contribution is made
- the contributing employer will only obtain tax relief when the benefits are payable
- the benefits from future FURBS funds will not be free from IHT on death
- all FURBS will pay tax at 40% on income and capital growth.
HMRC have put measures into place which restrict the ability to “recycle” tax-free cash lump sums by reinvesting them into a pension. Severe penalties will be applied where an individual takes tax-free cash of more than £15,000 and greater than 30% of it is reinvested into pensions. The regulations are very complex but are only to be applied where the recycling is thought to be “pre-planned”.
Pension planning can be complex and no action should be taken as a result of reading this insert without taking independent professional advice.
Who should I contact?
It is imperative that everyone reviews their pension arrangements and considers the potential effects of this legislation. In order to establish the practical implications for yourself or your business, please contact your Independent Financial Advisor or Find an IFA.