Pension Contributions

& Tax Relief - All Change!

The current Government has replaced a series of complicated changes originally put on the statute book by the previous Government and which specifically targeted high earners.

From April 2011, a new reduced annual allowance for tax-free pension saving will apply to everyone, irrespective of earnings position.

It seems the ‘Pension Simplification’ rules that were first introduced with great fanfare in April 2006 have been getting anything but simpler over the last few years, with continuous tinkering from our previous Chancellor.

However - although I may risk sounding like Neville Chamberlain - the most recent round of changes to pension contribution limits and tax relief may provide the closest yet to ‘peace in our time’  in terms of improved clarity and fairness.

Most importantly, full tax relief will be available to all.

The main changes

• The reduced annual allowance for tax-free pension saving for 2011-12 will be £50,000, rather than £255,000.
• From 6 April 2011, the more restrictive interim allowance of £20,000 for high earners will be removed.
• There will be a carry-forward rule that allows unused annual allowances from the previous three tax years to be used. This is an important development for high-earning NHS pension scheme members.
• £50,000 of annual allowance is equivalent to a 1/60th final-salary pension accrual of £3,125pa, whereas previously £50,000 was equivalent to an accrual of £5,000pa. As it's now easier to breach the limit, this is less good news for high-earning NHS pension scheme members.
• The lifetime allowance - the maximum level of benefits that a member can draw from all registered pension schemes without incurring penal tax charges - will be cut from £1.8m to £1.5m from 6 April 2012. Not such good news.
• Tax relief for all pension saving up to the new allowance will be granted at a tax payer's highest rate of income tax, with any excess taxed as income tax through self-assessment.

Doing the sums

For people in stakeholder pension schemes and other personal pension schemes such as SIPPs (self invested personal pensions), working out if they have gone above the new annual allowance will be simple.

They will simply have to add up the total contributions to a scheme in the financial year.

Doctors and dentists who are members of final-salary schemes such as the NHS Pension Scheme will have to perform a different calculation.

They will have to work out by how much their accrued pension has increased and multiply it by 16 (and, in the case of 1995 NHS Scheme members, add on tax free cash). That sum will be the total that counts towards the annual allowance.

So, an increase in pension rights of £3,125pa in the space of a year uses up £50,000 of annual allowance for a 1/60th scheme member, whereas an increase of £2,631pa for a 1/80th scheme member (allowing for tax free cash being added) would similarly use up the £50,000 allowance.

However, the effect of inflation during the year will be removed from the calculations. It will only be the increase in pension accrual over and above the rise in the consumer prices index that will be taken into account.

Unused allowances and carry-forward

The Treasury has included the facility for unused allowances to be allowed to be carried forward. This is to help mitigate the possibility of someone getting a nasty shock by being presented with a large retrospective tax bill, simply as a result of getting a pay rise after many years of contributions to an employer's pension scheme such as the NHS.

Under the forthcoming new rules, unused annual allowances for the previous three tax years can be carried forward and added to that year's £50,000 allowance.

For the tax year 2011-12, the first of the new regime, the Treasury has said that carry-forward will be available against an assumed annual allowance of £50,000 for the tax years 2008-09, 2009-10 and 2010-11.

Importantly, this facility is also available to personal pension contributions and offers a great opportunity to maximise tax relief of up to 50% on a large contribution which would not have been possible under the previous rules.

For example

Consider a final-salary scheme such as the NHS providing a pension of 1/80th pensionable pay for each year of service at retirement.

At the start of the year a member's pensionable pay is £90,000 and he/she has 30 years of service.

The value of his/her pension rights at the beginning of the year would be 30/80 x £90,000, equalling £33,750pa, plus a lump sum of £101,250.

Multiply the annual pension by 16 and add the tax free cash and you get a £641,250 pension pot.

At the end of the year, his/her pensionable pay has risen to £100,000 due to a promotion and he/she now has 31 years of service. The annual pension at the end of the year would now be calculated as 31/80 x £100,000, equalling £38,750pa plus a lump sum of £116,250.

Thus the value of the pension pot would be £38,750 x 16 plus the tax free cash, making a total pot of £736,250.

The increase in pension rights during the year would therefore be £736,250 minus £641,250, or £95,000.

So, ignoring inflation for a moment, he/she might have to pay an annual allowance charge on the £45,000 surplus over the £50,000 limit, depending on whether any carry-forward relief is available.

If the person in the above example had at least £45,000 of unused relief, he/she wouldn’t have to pay any tax at all.

The impact of the changes

The main impact of these changes for NHS Pension Scheme members is that long-serving scheme members who receive promotions, or other above-inflation pay rises that push the increase in their pension pot above the annual allowance, may be liable to tax charges.

It’s essential to take advice regarding utilisation of the ‘carry-forward’ rules in these circumstances.

For contributions to personal pensions, it’s important to ensure you optimise contributions and tax relief.

One important aspect of this will be to evaluate how you stand in relation to the ‘carry-forward’ opportunity and whether you have a combination of NHS non-NHS earnings which need to be taken into account.

Our view and summary

The changes are a practical method for overturning the last round of very complicated regulations, introduced by the previous Government in 2009, which capped tax relief for those with income of over £130,000. 

The new annual allowance gives each individual a clear cap on pension contributions or pension accrual with full tax relief. 

The Government estimates that 100,000 people in the UK will be affected by the change in the annual allowance.

Related links: NHS Pension Scheme: High Earners Factsheet (Source: NHS Business Services Authority)

Article by Malcolm Norris BA DipPFS
Independent Financial Adviser at Legal & Medical Investments
February 2011