C3.01: INDIVIDUAL PENSIONS ELIGIBILITY, LIMITS AND TAX RELIEF

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1 C3.01: INDIVIDUAL PENSIONS ELIGIBILITY, LIMITS AND TAX RELIEF SYLLABUS Eligibility Annual limit for relief Obtaining tax relief Anti-forestalling Practical application of tax relief Annual Allowance Lifetime Allowance Lifetime allowance tax charge Eligibility Reflecting the nature of the simplified pensions regime, there are no restrictions on eligibility for registered pension schemes However, there are restrictions on who can contribute with tax relief In order to benefit from relief, a contribution must be a relievable pension contribution paid by a relevant UK individual (or on his behalf) Relievable contributions are restricted to those paid before the individual reaches age 75 They may be paid by the individual, or someone on his behalf (for example, a parent paying a contribution to an arrangement for a child) However, employer contributions are excluded (this is discussed further below) Also excluded are contributions paid by HM Revenue & Customs (HMRC) as a result of the individual having contracted out of the State Second Pension (S2P) Generally, transfer values and pension credits arising on divorce or dissolution of a registered civil partner are also outside of the definition of relievable contributions To be a relevant UK individual for a particular tax year, the individual must: - have relevant UK earnings chargeable to income tax in that tax year; or - be resident in the UK for tax purposes for at least part of the tax year; or - have been UK resident for tax purposes at some time in the five tax years preceding that in which the contribution is made AND have been so when the individual joined the scheme; or - have general earnings from overseas Crown employment which are subject to UK tax, or be the spouse or registered civil partner of someone who does Relevant UK earnings include: - employment income (whether salary, bonuses, commissions, taxable benefits, overtime etc); - income from a trade, profession or vocation; - patent rights; and - general earnings from overseas Crown employment which are subject to UK tax Annual limit for relief Contributions can be paid by individuals without limit However, tax relief can be obtained by an individual only on contributions each tax year up to the annual limit for relief

2 This is the higher of: - 3,600, or - 100% of UK relevant earnings These figures relate to the gross contribution, even where some or all relief is obtained at source Other income such as savings income or dividend income does not affect the annual limit for relief Note that the annual limit for relief is a different concept from the annual allowance, which is discussed below If an employee earns more than the annual allowance (see below), relief will be obtained on personal contributions up to 100% of earnings, but a tax charge arises on contributions above the allowance, which effectively cancels out the relief Note that the last Labour government announced that from 6 April 2011, tax relief for high income individuals will be restricted, although this decision is being reviewed by the new government In the meantime, anti-forestalling measures have been introduced which can have the effect of limiting tax relief for some individuals in the interim These aspects are covered later in these notes Obtaining tax relief As was the case before A-Day, relief on personal contributions may be obtained in a number of ways, as follows: - the net pay arrangement where contributions are deducted from pay before calculation of tax, which gives relief at higher rate(s) immediately where applicable - relief at source (RAS) where contributions are paid net of basic rate tax, with relief at higher rate(s) claimed through self-assessment where applicable - gross contributions, with all relief claimed through self-assessment It was originally intended that existing retirement annuity contract providers would have to operate RAS from April 2007, but this was not enforced RACs can therefore continue to accept contributions gross, with all relief claimed from HMRC by the contributor through self-assessment Otherwise, gross contributions with relief through self-assessment are unusual, but can occur in a limited number of circumstances, which are: - where a contribution is paid to a public service scheme by a member who is not an employee (eg a doctor in general practice who is contributing to the NHS Pension Scheme) - where a contribution is paid to an occupational scheme which utilises the net pay arrangement by a third party for the benefit of a member It is also possible that a contribution is paid to an occupational scheme which utilises the net pay arrangement and the relief due exceeds the amount of tax deducted through PAYE for that employment, in which case the balance of relief can be claimed through self assessment Individual schemes other than RACs, for example personal pensions, must operate RAS Under the RAS method, basic relief (at 20% in 2010/11) is given at source, and applies even in the case of non-taxpayers Contributions by person A on behalf of person B (eg by a parent A on behalf of a child B) will be treated as personal contributions by person B for limit and tax relief purposes

3 For example, if a parent pays a contribution to a personal pension (PP) for a child who has no earnings and is a non-taxpayer, an amount up to 2,880 net (equivalent to 3,600 gross) can be paid with tax relief The earnings and tax position of the parent are not relevant and in particular, no relief at higher rate(s) would be available, even if the parent was subject to tax at rate(s) above basic rate There is no restriction on who can pay contributions for the benefit of others, but in the case of a child, the PP must be taken out by a parent or guardian, who would take responsibility for ensuring that total contributions were within allowances Note that there is no longer any carry-back of contributions for tax relief purposes (this facility used to allow contributions paid in one tax year to be carried back to the previous year for tax relief purposes) Contributions paid by an employer are always paid gross and are generally treated as a deductible business expense (but must be justified to the Inspector of Taxes as such) Employer contributions are not a taxable benefit for employees and there is no tax liability for employees in respect of them (unless the annual allowance is exceeded) Practical application of tax relief Relief at higher rate(s) is given by increasing the basic rate tax band (and therefore the threshold for both higher rate and the new additional rate) of the contributor by the amount of the gross contribution The effect is to give relief at higher rate(s) on the contribution to the extent it is matched by income that would otherwise be taxable at those higher rate(s) For example, suppose and individual has income, all of which is earned, and which is 1,000 over the higher rate tax threshold, before allowing for any pension contributions He then contributes 800 net (equivalent to 1,000 gross) to a PP, with the result that the higher rate threshold increases by 1,000, entirely removing the higher rate liability The total relief is 40%, given as 20% through RAS plus 20% as a result of the top 1,000 of his income which would have been taxed at 40% now being taxed at only 20% If the same individual contributed 2,000 rather than 1,000, only 1,000 would be relieved at 40%, and the rest at 20% For an individual with income of 200,000, all earned, if no pension contribution was paid, the top 50,000 would be subject to the new 50% additional rate (the income level means that no personal allowance is available) Now suppose he pays a contribution of 4,000 net (equivalent to 5,000 gross) under the RAS system and assume the anti-forestalling provisions are not triggered The higher rate (40%) threshold will increase from 37,400 to 42,400 and so the amount of income taxed at 20% increases to by 5,000 to 42,400 The additional rate (50%) threshold increases by 5,000 from 150,000 to 155,000) The band of income subject to 40% remains the same ie 112,600 ( 150,000-37,400 = 155,000-42,400 = 112,600) The amount of income taxed at 50% is reduced by 5,000 to 45,000 The tax saving results from 5,000 which was previously taxed at 50% is now taxed at 20% The saving is therefore 30% = 1,500

4 Added to the 1,000 relief given through RAS, this means that the total relief is 2,500 ie 50% of 5,000 Where income is partly in the form of dividends, the amount of relief at higher rate(s) is increased in some cases For example, suppose a higher rate taxpayer has earned income which takes him exactly to the higher rate threshold and a further 1,000 of dividend income, all of which falls into higher rate If he contributes 800 net (equivalent to 1,000 gross) to a PP, he has received 20% tax relief through RAS In addition, the 1,000 dividend income now falls into the basic rate band and is taxed at 10% rather than 32.5%, therefore gaining at extra 22.5% tax relief, to give total relief of 42.5% Now suppose earned income is exactly 150,000 and there is a further 1,000 of dividend income which would be taxed at 42.5% (the additional rate for dividends) If again a net 800 (gross 1,000) contribution is paid, the effect will be to remove the 1,000 from additional rate and reduce the tax to 10% The total tax saving is therefore 20% through RAS and 32.5% through self assessment, giving a total of 52.5% The effect only occurs when the payment of the PP contribution and the resulting increase in the basic rate band means that some dividend income which previously fell into higher or additional rate now falls into basic rate Annual Allowance The annual allowance was initially set at 215,000, and has increased each year since, reaching 255,000 for 2010/11 The total pension input amount for an individual is tested against the annual allowance The total pension input amount is: - total gross contributions (including any made by an employer) to defined contribution (DC) arrangements other than cash balance schemes - the increase in the value of retirement benefits (but not death before retirement benefits) under defined benefit (DB) arrangements and cash balance schemes The input amount in respect of any particular scheme is measured for the scheme input period ending in the tax year concerned The input period is defined by the scheme administrator in the case of a DB scheme, but for other schemes, it can be set by the member or the scheme administrator The input period may not therefore coincide with the tax year, so care is needed in applying the allowance in cases where the input is considerable Individual pensions are necessarily DC arrangements, so the total of contributions is the relevant figure Note that it is gross contributions which are taken into account, even where some or all tax relief is given at source However, where an individual has benefits under more than one scheme, the relevant figures from all schemes are aggregated in order to test against the annual allowance If the annual allowance is exceeded, a personal income tax charge on the member arises on the excess at the rate of 40% This applies irrespective of the individual s tax position, though in practice it is likely that the contributor is a higher or additional rate taxpayer

5 It was thought that the rate of charge might increase to 50% when the additional rate of tax was introduced from 6 April 2010, but this has not in fact happened The annual allowance has increased each year through the initial five year period of the simplified regime However, it will then be frozen at that level for the following five years, up to and including 2015/16 This may change in the future, possibly by a substantial reduction in the allowance - this is an alternative to the restriction of higher rate relief planned by the previous government The pension input amount under a registered scheme for a tax year in which all benefits are taken in full does not count towards the annual allowance In the year when benefits are taken, they are tested against the lifetime allowance (see below) in the normal way when the Benefit Crystallisation Event (BCE) occurs Contributions by an individual which do not qualify for relief (eg because they exceed 100% of earnings) do not count towards the annual allowance Also ignored are: - National Insurance (NI) rebates resulting from contracting out under PPs or DC occupational schemes and paid direct to the scheme by HM Revenue & Customs (HMRC) - transfers in received from other registered schemes Note that under DC schemes such as PPs, only contributions are counted towards the allowance, and the investment performance has no effect (whether positive or negative) Anti-forestalling It was announced in the April 2009 Budget that relief on pensions input would be restricted for high income individuals from 6 April 2011 The proposals were to affect high income individuals defined broadly as those whose income is 150,000 or more The relief was to be tapered down and the effect will be to restrict relief to basic rate for those whose income is 180,000 or more Note that concerns about the implementation cost have prompted the new government to review the change to try to identify simpler alternatives The most likely outcome of this is a reduction in the annual allowance to a level between 30,000 and 45,000, probably also accompanied by an increase in the valuation factor used when testing the annual allowance In the meantime, as a transitional measure, anti-forestalling provisions were introduced with effect from 22 April 2009 (Budget Day in 2009) These were intended to prevent individuals who might be affected by the reduction in relief from boosting contributions beyond their normal pattern to maximise relief in the period before 6 April 2011 They have not been amended by the new government The measures as announced only apply where a number of conditions are all met These are that: - the individual has income in the current tax year or either of the previous two tax years which at least reaches a specific level; and - their total pension input in the current tax year is more than the Special Annual Allowance (SAA); and

6 - input in excess of their normal input pattern (which, subject to conditions, is protected) occurs The SAA is generally 20,000 less the protected level of input (if this is negative, the SAA is zero) The specific level of income was originally set at 150,000 from 22 March 2009 but was reduced to 130,000 from 9 December 2009 In determining income, all income (not just earnings) is taken into account, and pension contributions can be deducted, but only up to a maximum of 20,000 pa Grossed up gift aid contributions are also deducted Any salary sacrifice entered into on or after 22 April 2009 (or 9 December 2009 for those only affected when the relevant income level was reduced to 130,000) in return for increased employer pension contributions is added back in determining income for this purpose Note that the anti-forestalling provisions apply to input Under DB schemes, this is calculated based on the increase in accrued benefit over a year, in broadly the same way as for the annual allowance test Under DC schemes, input includes employer contributions to DC schemes as well as the gross contributions paid by the individuals themselves The normal pattern of input (the protected input) will reflect contributions to DC schemes, including increases relating to salary where there is a contractual rate of contributions Regular contributions are protected only if paid at least quarterly If non-regular (eg annual or one-off) contributions have been paid in the past, and their average over the tax years 2006/07, 2007/08 and 2008/09 exceeds 20,000, the SAA is increased This is achieved by using the average non-regular input figure, with a maximum of 30,000 in calculating the SAA rather than the usual 20,000 Where the measures apply, there will be a special annual allowance tax charge on any increase in input which is above the protected level and exceeds the individual s SAA For example, suppose the protected regular input level was 1,000 per month (ie 12,000 per year), and so the SAA is 20,000-12,000 = 8,000 If the individual maintains this in 2010/11 and pays a one off 10,000, the tax charge applies to the excess over the SAA ie 10,000-8,000 = 2,000 If the protected regular input level was 3,000 per month ( 36,000 per year), the SAA would be zero If the individual maintains contributions at 3,000 per month and pays a one off 10,000, the tax charge applies to the whole 10,000 The tax charge is such as to reduce the relief to basic rate, so it was 20% in 2009/10 In 2010/11, the rate of charge is 30% for 50% tax payers and 20% for 40% taxpayers A sliding scale applies where the relief would otherwise be given partly at 40% and partly at 50% Where the input is employer contributions, the tax charge means that the contributions will be taxed at the SAA tax charge rate, whereas in the past they have been free of tax

7 Lifetime Allowance The simplified regime has introduced a lifetime allowance This is the maximum amount which an individual is permitted to build up with the benefit of the full tax advantages associated with pension arrangements The standard lifetime allowance (SLA) was initially 1.5m in 2006/07 and has increased each year since, reaching 1.8m for 2010/11 The allowance will then be frozen at that level for the following five years, up to and including 2015/16 Under DC arrangements, the fund at the time benefits are taken will be tested against the lifetime allowance If the fund exceeds the lifetime allowance, a tax charge applies (see below) Under DC arrangements, including individual pension schemes, it is possible to incorporate a scheme pension facility in the rules This is generally uncommon under PPs, but it does allow benefits to be valued on the same 20:1 factor that applies in valuing benefits under defined benefit occupational schemes, even if the real cost of the benefits is greater Note that the testing of benefits which arise under occupational schemes, including defined benefit schemes, is covered in a separate syllabus topic The scheme pension basis may be beneficial particularly where a member takes benefits relatively early For example if a member retires at 55 with a fund of 2m, and the fund is tested against the lifetime allowance, a tax charge would arise on the excess (see below) If the fund provides a scheme pension of (say) 80,000pa, this would be valued for testing purposes at 80,000 x 20 = 1.6m, so no lifetime allowance tax charge would apply The member would lose the ability to use an Open Market Option to improve annuity rates, but must have been offered the alternative of buying a lifetime annuity, which could have been purchased on the open market The lifetime allowance covers the total value of personal benefits built up under all arrangements, irrespective of when they were funded Testing against the allowance generally occurs when benefits come into payment (known as a benefit crystallisation event or BCE), not before Only benefits coming into payment at the time are tested Any benefits under as yet unvested arrangements are ignored until they vest There will not therefore be any restriction on further funding, or on reliefs simply because a fund which has not yet crystallised exceeds the allowance If benefits are taken at different times, the lifetime allowance will be gradually used up For example, suppose an individual has had two arrangements and in 2009/10 he crystallised all his benefits from one arrangement, which had a fund of 700,000 The remaining lifetime allowance in 2009/10 would have been 1.05m (ie 1.75m - 700,000) The remaining allowance will increase in line with increases in the normal lifetime allowance

8 For example, if he crystallises benefits under the other arrangement in 2010/11 when the standard lifetime allowance is 1.8m, the residual allowance available will be 1.05m x 1.8/1.75 = 1.08m In practice this is dealt with by expressing the remaining allowance as a percentage of the SLA In the example above, the first BCE used 40% of the SLA ( 700,000 of the SLA of 1.75m), leaving 60% available for future crystallisations The amount available in 2010/11 is therefore 60% of 1.8m = 1.08m Pensions already in payment at A-Day will be counted towards the lifetime allowance if a crystallisation event occurs, using a conversion factor of 25 for each 1 pa of pension They will use some, or possibly all of the lifetime allowance at the time of the first post A-Day crystallisation event No tax charge can arise in respect of the benefits in payment at A-Day, even if their value exceeds the lifetime allowance The conversion factor is higher than the usual 20:1 factor which applies in valuing pensions under DB occupational schemes because it takes into account the fact that in most cases, a cash benefit will also have been taken when the pension started However, it is not reduced even if it can be shown that in fact no cash was taken, or even if could not be taken at all If cash was taken, its actual amount is ignored (the higher valuation factor has already allowed for the likely receipt of cash) Where existing benefits are being taken under an income withdrawal arrangement, the income level for this purpose will be taken as the maximum permitted level, as calculated at the most recent review This maximum is used irrespective of the amount actually being withdrawn at the time (which could be nothing The usual 25:1 valuation factor applies Lifetime allowance tax charge If the fund being used to provide benefits exceeds the lifetime allowance (or the remainder of the allowance, where applicable) there will be a lifetime allowance tax charge This will be at the rate of 25% of the excess if benefits are then taken from the excess in the form of income, which would be taxable in the usual way Alternatively, all or part of the excess above the lifetime allowance can be taken as a cash lump sum, but after deduction of a lifetime allowance tax charge of 55% (rather than 25%) from the part taken in cash There would then be no further tax liability on the lump sum There are no restrictions on the proportion of excess benefits available in the form of cash The lifetime allowance tax charge will generally be deducted from benefits and paid to HMRC by the scheme administrator