UK: Pension Tax Relief on a Cliff Edge

The amount of tax-effective contributions that can be paid into a pension scheme is about to go over a cliff. It is already too late for some.

CEOs and other high earners may already be affected by the last Government's 'anti-forestalling' provisions, which were designed to prevent those on high incomes from taking advantage of the prevailing limit on tax-effective pension contributions (known as the 'annual allowance') before stringent new restrictions were introduced in April 2011.

The present Government recognised that the incoming restrictions were unreasonably complicated and after consulting interested parties, repealed the relevant part of Finance Act 2009, replacing it with a simpler but no less dramatic reduction in the annual allowance from the 2011/12 tax-year.

Annual allowance from 6 April 2011

The new annual allowance is to be £50,000, down from £255,000 today. Beyond this level of contribution, a tax charge will be levied on an individual applied to the amount of the excess contribution. This will be at the person's marginal rate of tax and applies whether or not he or she makes any personal contribution.

There will be a notional allowance of £50,000 for each of the three years preceding tax-year 2011/12, against which actual contributions should be offset (oldest first). Thereafter, it will be possible to carry forward unused allowances for each of the preceding three years. An individual needs to have been a member of a registered pension scheme in the relevant years, in order to have a notional allowance for those years.

Assessing contributions

It is easy to identify contributions under a defined contribution (DC) arrangement, such as a personal pension or an occupational money purchase scheme, but for those who participate in defined benefit (DB) schemes ('final salary' or 'revalued average salary'), comparing a year's worth of pension accrual with the new allowance is a little more complicated.

Defined benefit accrual and the annual allowance

There has been a considerable decline in DB schemes over the last few years although many of those in the not for profit sector (such as housing associations) have tended to keep their schemes open to existing members for future accrual. Public sector schemes currently remain open to new entrants, although this whole area is under review.

In order to value the amount of pension benefit that has accrued during a year, the benefits are valued at the beginning of the year and compared with those at the end of the year. The opening value is increased by the Consumer Prices Index (CPI), so as to remove the effects of inflation. Pension is capitalised by a factor of 16, irrespective of the level of attaching pension increases or associated spouse's pension.

Example 1 (typical year)

Increase in capital value: £46,800, which is below £50,000 so there is no tax liability and £3,200 will be available to carry forward for up to three years. Let us now consider a situation where the person is awarded a promotional increase of 10% during the year.

Example 2 (promotion within year)

Increase in capital value: £83,200

Potentially chargeable to tax (at 50%): £33,200, if no carry-forward available

If the current salary is around £150,000 per annum, depending on the years of service, even a 5% increase in salary will result in a charge to tax, where no carry-forward is available.

It is important that high-earning members of DB schemes (final salary schemes, in particular) consider how future salary progression might cause the £50,000 annual allowance to be exceeded. Unlike the annual allowance of £255,000 that will shortly expire, the new allowance is not subject to any scheduled review. This means that £50,000 should be regarded as the annual allowance for the foreseeable future.

Is it already too late?

Many people will assume that there is still time to make higher contributions before the rules change. In general, anti-forestalling will prevent this for those with incomes over £150,000. This reduces the effective tax relief to the basic rate where pension savings in the year exceed £20,000, but with some protection for ongoing arrangements.

Where a pattern of regular contributions (paid at least quarterly) existed before 22 April 2009 it can be maintained, even though these may far exceed £20,000. Also, if in the three tax years ended on 5 April 2009 'irregular contributions' averaged over £20,000, the limit is increased to that figure subject to a £30,000 cap.

Anti-forestalling arrangements are only transitional and will be replaced in April 2011 by the new £50,000 annual allowance.

Pension input periods

One might think that the present £255,000 annual allowance and anti-forestalling arrangements will cover the whole of the 2010/11 tax year. This is not necessarily true. Every pension arrangement has a 'pension input period', which was introduced when pensions were 'simplified' in April 2006 (A-Day). The annual allowance is determined by the tax year in which the pension input period (PIP) ends.

Few schemes took action to select their own PIP, with the result that a default PIP applied. The first default PIP for DB schemes was a year and a day from 6 April 2006 to 6 April 2007. Subsequent PIPs ran from 7 April to 6 April. By default, therefore, most DB schemes will have a current PIP that ends in tax-year 2011/12. This means that the new £50,000 annual allowance already applies.

The default PIP for DC arrangements ran for whole years from the date of payment of the first contribution after A-Day, so again, many schemes of this type will be already affected by the new allowance.

Transitional arrangements

The present government announced its new plans for pension contributions on 14 October 2010, while the £255,000 allowance was in force, amounting to a mid-year change. Transitional arrangements permit the full £255,000 to be paid for a member under any scheme with a PIP that ends after 5 April 2011, so long as no more than £50,000 is paid after 14 October 2010 and subject to anti-forestalling restrictions, if applicable.

Options available

In order to avoid tax penalties in the future, high earners will need to ensure that increases in their 'pensionable salaries' remain within the new allowance. This may require a change to the scheme rules (which should define pensionable salary) and/or a change in the employment contract, perhaps separating pensionable salary from other definitions of salary.

Any curtailment of pensionable salary will amount to a reduction in a person's overall benefits package, so thought will need to be given to other forms of remuneration to compensate for the loss.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.