Taxation of Pensions
The current Pensions regime came into force with effect from 6 April 2006 although there have been further amendments subsequently.
The rationale for the new regime was ‘simplification’ although the legislation has now become relatively complex.
The thrust of the legislative change was to create one overriding set of rules to apply to all pension provision. This has, with a few notable exceptions, been achieved. This document outlines the broad principles governing pensions today.
There is no limit on the level of pension contributions that can be made for any individual but the nature of tax relief and tax penalties effectively create limits within the regime, as follows:
- Contributions of up to £3,600 can be made for any individual under age 75 attracting basic rate income tax relief regardless of whether they are a taxpayer or their level of earnings
- Member contributions attract tax relief at the individual’s marginal rate of tax up to a level equal to 100% of their earnings within a tax year
- There is no limit on employer contributions and providing they can be shown as having been incurred wholly and exclusively for the purpose of the business, they would usually attract corporation tax relief in the year of payment (although if the contributions made by an employer either directly or indirectly exceeds 210% of their previous year’s contributions, tax relief may be split over a period of up to four years)
- Where the total combined member and employer contributions exceed the annual allowance, the member would be subject to an annual allowance charge of 40% of the excess contribution. The 2008/2009 annual allowance is £235,000 rising to £255,000 by the 2010/2011 tax year.
- In the tax year of retirement no comparison is made between the contributions and the annual allowance. This means that contributions could exceed the annual allowance in that year without an annual allowance charge
All arrangements have the same basic maximum benefit rules. At retirement, a tax free cash lump sum is available with the remaining fund being used to produce an income which is taxable at marginal rates.
These rules apply to all pension funds within the lifetime allowance. The lifetime allowance is £1.65m for the 2008/2009 tax year, increasing to £1.8m by the 2010/2011 tax year. If an individual’s fund exceeds this limit at retirement, the excess will be subject to a lifetime allowance charge of 25%.
All benefits from the excess fund will be taxed and will be available either as an income, taxable at marginal rates, or a lump sum, taxed at an additional 40%. A higher rate taxpayer will, therefore, pay an effective tax rate of 55% of all funds in excess of the lifetime allowance.
Within these overall benefit rules, it will still be possible for schemes to have different benefit structures. For instance, a defined benefit (or final salary) scheme can still exist and provide guaranteed levels of pension. The values of these benefits will be monitored against the lifetime allowance and the fund will be taxed where benefits exceed the allowance at retirement. Standard commutation factors apply to measure the lifetime allowance and annual allowance.
Tax free cash
The tax free lump sum available is equal to 25% of the fund at retirement. In many cases this is greater than was available under previous legislation.
If the benefits accrued in an occupational pension scheme up to 5 April 2006 provided for a tax free cash lump sum of greater than 25% of the fund, these rights can be preserved providing they are held within that scheme until retirement. In most cases, transferring out of that scheme will remove the right to the protected cash lump sum.
Benefits from a pension arrangement can be ‘crystallised’ – and used to pay benefits – at any age from 50 but this minimum age will increase to 55 by 2010. Benefits must commence by age 75.
It is now possible to take benefits from pension arrangements regardless of whether the member continues to be employed.
Income in retirement
Once a cash lump sum has been taken, an income becomes payable. This can be provided in one of three ways – secured income, Unsecured Pension (USP) or Alternatively Secured Pension (ASP).
A secured income is provided, either via the purchase of an annuity or by a pension scheme guaranteeing the income payable to an employee.
An unsecured pension income is significantly more flexible. There are a number of ways in which these can be provided but usually it is done by pension fund withdrawal where the income is provided directly from the funds invested. Pension fund withdrawal means that:
- the maximum level of income is calculated as 120% of the level indicated by the Government Actuary’s Department (GAD) tables and reviewed every five years
- there is no minimum income
- in the event of death before age 75 a spouse can continue to receive the income or the funds can be available as a lump sum subject to 35% tax
- unsecured income can continue only to age 75 when an individual can either have benefits provided as secure income or utilise an alternative secured pension (ASP).
ASP is a continuation of the pension fund withdrawal principle, but with maximum and minimum levels of income set at 90% and 55% respectively of GAD income.
In the event of death whilst in ASP the remaining fund must be used to provide a dependants pension. If there are no dependents then the options are a transfer lump sum to other members of the same pension scheme or a charity lump sum death benefit.
However the transfer lump sum death benefit will be an unauthorised payment and will be subject to penal tax charges and inheritance tax.
Inheritance tax charges may also apply to annuities and scheme pensions of all registered pension schemes and are not limited to ASP.
There is a limit on the maximum lump sum death benefit available which is equal to the lifetime allowance. Lump sum benefits in excess of that are subject to a tax penalty of 55%.
There is no limit on death benefits provided in the form of a taxable income to a spouse or dependants.
It is no longer possible to establish a contract funded by an employee which provides lump sum death benefits and attracts tax relief in respect of employee contributions.
Transitional protection is available for those with rights before 6 April 2006 that would be affected by the new limits. Members seeking to protect existing rights, that may exceed the lifetime allowance, have until 5 April 2009 in which to register for protection. There are two forms of protection: primary protection and enhanced protection.
Under primary protection, those individuals whose fund exceeded £1.5m at 6 April 2006 would be granted a higher lifetime allowance up to the level of those benefits.
This personal lifetime allowance is increased in parallel with increases with the lifetime allowance up to the date benefits are taken. This protects existing funds from the lifetime allowance charge. However, the lifetime allowance charge could still apply to future fund growth and the funds derived from future contributions.
Enhanced protection is available to any individual who commits to cease active membership in all pension arrangements after 5 April 2006. Providing they do not resume membership of any registered pension scheme, all benefits coming into payment will be exempt from the lifetime allowance charge.
These transitional arrangements are complex and specific advice should be taken prior to entering into any of these arrangements.
In most cases investment rules apply to all pension schemes and have allowed for a widening of some of the types of investments available.
There are limits on the holdings of shares in a sponsoring employer and limits on loans to employers. They also limit the amount of borrowing by a pension fund which is usually more restrictive than previous legislation.
Any investments made prior to the change in legislation are subject to transitional rules and the scheme is protected from having to make urgent disposals of assets that are incompatible with the new rules.
Who shall I contact?
It is important that individuals and employers understand the workings of a pension regime, particularly if they have significant benefits accrued prior to 6 April 2006. If you have any concerns over the way in which the legislation changed or about providing benefits under the current regime, please contact your Independent Adviser who normally deals with your tax or financial planning affairs.