UK: Budget 2009: Pensions - What Do The Changes Mean For You?

Last Updated: 13 August 2009
Article by Philip Moss, Sandra Brown and Christopher Kerr-Smiley

Originally Published on 9th June 2009

Introduction

One of the headlines in the Chancellor's Budget was that, from April 2011, tax relief on pension contributions will be restricted for those with incomes of £150,000 and over. Under the changes, the value of the relief will be tapered down until it is worth just 20% for those earning £180,000 or more. Those with incomes below £150,000 will continue to enjoy tax relief at up to 40%.

The Government has justified this by stating that those with incomes of over £150,000 represent only 1.5% of pension savers, but receive a quarter of the cost of tax relief on contributions. That benefit will increase still further when the top rate of income tax goes up to 50%. Having said that, the FT recently suggested that 17% of all income tax receipts are paid by the richest ½% of taxpayers!

The changes are subject to consultation and implementation is still almost two years away, but what does it mean for us all now? We address this question below, but one thing is certain – the impact of the changes will be felt immediately. This note describes the immediate impact on the individuals who benefit from pensions. There will also be administrative issues for pension fund managers, which we shall cover as more detail and certainty emerges.

Which schemes are affected?

Clearly, high earners funding their own schemes (whether self-employed or employees with a money purchase scheme) will immediately recognise that the proposals may hit them.

  • Such high earners will still get 20% tax relief on contributions to their pension, which may still make the investment worthwhile, subject to an analysis of the benefits to which we shall return.
  • Consideration may be given to making a couple of big contributions into the pension fund ahead of the change, but they will have to contend with some new rules (the "anti-forestalling rules"), which may limit relief to 20% with immediate effect.

High earners in company schemes may feel that they will be unaffected. Why do they need to worry as the company looks after their pension provision, so that they do not claim tax relief on any contributions? They also need to be concerned because, although we do not yet know what the rules for 2011 may look like, company schemes are affected by the anti-forestalling rules. If the anti-forestalling rules apply, so will the final rules in 2011.

When do the anti-forestalling rules apply

The anti-forestalling rules take effect immediately. We hope that HMRC may moderate them and it may be that there is a role for each of those affected to play, by making representations to the Government. At present, these rules will apply to any individuals:

  • who have annual taxable income of £150,000 or more in any of the tax years 2007-08 to 2010-11. This refers to all taxable income (not just earnings of that level) and includes employment income, savings income, pension, rental and any income from investments.
  • who increase their pension savings after 22 April 2009 beyond their "normal regular saving". It is the definition of "regular saving" that is especially harsh.

There is a de-minimis threshold of £20,000, below which the rules will not apply.

Where the rules do apply, there will be a tax impact. For 2009-10, there will be an income tax charge of 20%. That is the logical rate, as it is the difference between the higher rate and the basic rate. What happens in 2010-11 when the higher rate increases to 50%? Although not set out explicitly, one must assume that the income tax charge will rise to 30%.

How the anti-forestalling rules impact upon money purchase schemes

If one takes 2009-10 as an example, if the anti-forestalling rules apply, members of a money purchase scheme will in effect find that they are limited to relief at the basic rate on their contributions. So, if they had made a gross contribution of £100,000 prior to 22 April 2009 –

  • they would have paid £80,000 to the pension provider, who would recover the other £20,000 from HMRC; and
  • then claim the other £20,000 in their tax return at the end of the year.

For contributions made after 22 April 2009, it is that reclaim that will be taken away, or clawed back if an employee secures relief for this via the PAYE system.

The anti-forestalling rules may apply in unexpected situations. For example, if a self-employed person habitually makes an annual contribution when cash flow permits, that does not fall within the definition of "regular saving". That is especially harsh.

Effectively, contributions paid after 22 April 2009 are only protected to the extent that they were made on a quarterly or more frequent basis before that date and they do not increase beyond that (save to the extent agreed before that date).

Hence, even if an individual makes payments in accordance with past practice, where the prior payments were not "regular" for the purposes of the anti-forestalling rules, payments in excess of £20,000 will attract basic rate tax relief only, even for the current tax year. This is one of the main areas where we feel that it is worth people making representations to the Government, although early indications suggest that they may be willing to review this.

How the anti-forestalling rules impact upon final salary schemes

The impact of the anti-forestalling rules on final salary schemes suggest that HMRC has in mind a penal set of rules for the future. Here the anti-forestalling rules start by seeking to ascertain whether there is a material change to the way that the benefits are calculated. If this occurs on or after 22 April 2009, there may be a charge.

A material change is likely to include:

  • a change in the method of calculating final salary; and
  • an increase in the accrual rate.

There is a let-out where there are at least 50 active members in the scheme that also benefit from the change, so that the bigger risk is for smaller schemes.

The detail is complex, but we can illustrate the extent of the problem by using an example from the technical guide issued by HMRC. In the example, an employee is earning £150,000 per annum and has been working for the company since 1995. The benefits of the scheme are amended, so that the accrual improves from one-sixtieth of salary for each year of service to one-thirtieth (and all years of service since 1995 are included).

Clearly, this is a valuable enhancement, but enhancements are agreed commercially from time to time, either to improve benefits or possibly on a termination of employment maybe under a redundancy arrangement. When the maths is concluded, the value of the benefit in that example is £351,490, which will result in a tax charge at the rate of 20% on that individual of £70,298.

Clearly, members and managers of final salary schemes need to take care in the next couple of years to avoid these types of charges, or at least be sure that they are aware of the scale and scope of the charge. In particular, we all need to watch out for the rules applying in unexpected circumstances, as shown by the example of a variation as part of a package on a termination of employment.

What may the future hold?

We have focused in the text above on the anti-forestalling rules that are to operate up to 5 April 2011 when the ongoing new rules will start, restricting tax relief on pension contributions for those with incomes of £150,000 and over.

  • Consultation has been promised, and HMRC has yet to release any papers. There will be an election before 2011, so maybe nothing will happen.
  • If it does happen, however, one assumes that each year the value of certain benefits or enhancements to an individual's final salary scheme will be subject to an income tax charge where that person's taxable income is in excess of £150,000.
  • In equivalent money purchase schemes, tax relief on an individual's contributions will be limited to the basic rate alone and there will be a tax charge where the employer makes contributions.
  • If the highest rate of tax for such a person in 2011 is 50%, then one assumes that the rate of any tax charge will be set at 30% once income exceeds £180,000.

If this is correct, there may be an annual benefit in kind charge for these individuals where value accrues to the scheme in circumstances to be caught by the new rules. Please remember, at this stage we can only guess what the final outcome will be, as the consultation has not yet commenced. It may be that the final charge is moderated.

Analysis of the benefits

At the outset we made the point in connection with a money purchase scheme that an individual who is a high earner will still get 20% tax relief on contributions paid into a pension scheme, which may still make the investment worthwhile, subject to an analysis of the benefits.

It is also worth making the point that the A Day pensions changes themselves are not affected. Hence, in the current tax year and subject to the usual rules, a taxpayer may invest up to £245,000 into a pension scheme up to a current lifetime limit of £1.75m. These figures will rise to £255,000 and £1.8m respectively from 6 April 2010. Indeed, it is also worth making the point that individuals with incomes below £150,000 can still invest as before, with full tax relief. Some advisers are suggesting that these people should maximise their savings now, in case the rules tighten up further still.

But what are the economics for those affected by the new rules? Receiving 20% tax relief is still a savings benefit that enhances the value of the fund. Hence, at a net cost of £80,000 a taxpayer can add a gross equivalent of £100,000 to the fund. That is a distinct advantage as against not making a pension contribution and investing the net sum of £80,000 without any tax break.

Also, the investment of £100,000 grows tax free in the fund, whereas any return on an alternative investment of £80,000 in the market may suffer tax (at rates between 18% for gains and prospectively up to 50% for income). Hence, for many it still seems worthwhile investing in the pension fund, even with a lower level of relief.

However, when the money comes out of the pension fund, it is all income. So long as the Chancellor does not in future restrict this also, 25% of the pension fund can come out as a tax free lump sum on retirement, but the rest of the fund is taxed as income. There is a risk that the individual may pay higher rates on this income, which could significantly increase the overall cost. In contrast, when the individual cashes in an alternative investment there is no further tax to pay on the original capital.

Where does the benefit lie? That calculation is difficult to make and each person must consider that question with his or her own advisers. Other forms of saving may become popular, and it will certainly be worth individuals maximising their investments into ISAs.

The same kind of analysis applies to a final salary scheme, in that for a similar cost a fund is set aside that grows, but again the level of tax on the output is uncertain. Will this put off high earners from investing in pensions? Would they prefer to receive a higher level of initial remuneration that they can invest as they choose? If it does, then there is the risk that more company schemes will close.

There is much debate likely to follow here - we will keep you updated with developments that may affect you as and when they happen.

If you have any particular views that you would like to make, please do contact us so that we can discuss them with you. This applies to the anti-forestalling rules and the consultation that is promised for the ongoing new rules from 2011. It may be that your views can be added to others and passed on to the Government.

Since this article was first published the anti-forestalling rules have been enacted in Schedule 35 of the Finance Act 2009. Following much criticism of these rules amendments have been made in the Finance Act to the legislation originally proposed in the 2009 Budget. These changes mean that for those individuals who have made irregular contributions in the three tax years prior to 22 April 2009 in excess of £20,000, the special annual allowance will increase to the lesser of the amount of the average contribution over that period and £30,000. Whilst this does not go as far as many would have liked, it may help some individuals who have not made "regular contributions" over the past three years into their pension scheme.

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.

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