Tax Doctor:
Bob Fraser
MBE, MBA, FPFS, TEP, Chartered Financial Planner

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March 2006

Q:

I have not been interested in serious pension planning until now because of the restrictive and complex rules regarding earnings, age, contribution rates, and permissible annuity calculations. I understand that the rules are changing from April this year, and I wondered if I should be re-thinking my attitude. In what ways are the rules making it more flexible for me to plan for my retirement?

A:

You have not stated what type of pension is available to you, so I shall cover both money purchase and final salary schemes.

After A-Day you will be able to pay your full salary into a pension and get tax relief on your contributions. For example, if you are earning £40,000 per annum you will be able to invest the full £40,000 into your pension. However, all contributions which attract tax relief will be subject to the Annual Allowance, (see below).

If you are not employed and therefore do not receive an income or you earn less than £3,600 per annum, the maximum you can contribute to a pension is £3,600. What this could mean to you is that you may pay pension contributions for a non-working wife, or one who is paid at the level below which national insurance contributions are required, and still get basis rate tax relief on those contributions. See the article under Tax Investments on other ways to pension a working wife. It also means that a director taking drawings as dividends may still make modest pension contributions.

From 6 April 2006 you can contribute to any number of pension plans, with full tax relief as long as you don't contribute more than 100% of your salary (subject to the annual allowance) or £3,600 if higher. Whilst theoretically this could be a way to diversify your pension funds, in practice there are disadvantages to this approach, which would include administrative complexity in trying to monitor your policies, difficulties in managing your asset allocation across the various plans, and the possibility of increased costs (some providers give discounts for large sums). Many advisors believe that investors would do well to consider consolidating their plans into a Self Invested Pension Plan, particularly for the ability to improve diversification and asset allocation (see article on this subject in Tax Investments)

There is no limit on the contributions which can be made by an employer and the employer will receive Corporation Tax Relief on all contributions. However, where an employer is intending to make very large contributions for a director, or an associated individual, then advice should be sought from the local Inspector of Taxes. The reason is that tax relief will only be allowed if the contribution is seen to be 'wholly and exclusively' in the interests of the business. What this could mean for you is that if you are a director of a business with fluctuating profits, you could pay large contributions in highly profitable years, and none at all in lean years.

Although in principle you can pay all your salary into a pension and there is no limit on the contributions made by your employer, there is a ceiling on the annual level of tax relievable contributions or accrual of benefits - known as the Annual Allowance. The Annual Allowance for 2006/2007 is £215,000. For a Defined Contribution (DC) scheme (essentially a money purchase scheme, or personal pension arrangement) your own contributions and your employer's contributions are added and if the total is more than £215,000 you, the individual, will be liable for a 40% tax charge - effectively the excess is charged as a benefit in kind. For Defined Benefit (DB) schemes (also known as final salary schemes), the accrual of benefit is the increase in the value of rights over the scheme year. For active members this increase in value is tested against the Annual Allowance - the increase in pension over the year is multiplied by 10. If this is over £215,000 you will be liable for a 40% tax charge. What this means is that these excess contributions should be avoided since the excess could taken as cash and then re-invested outside a pension contract.

Contributions and accrual of benefit in the tax year in which benefits are taken in full will not be subject to the Annual Allowance limit. However, the benefit must be tested against the Statutory Lifetime Allowance (SLA). What this means is that if an employee (who could be a director) is retiring without a significant pension fund, and the business has the cash assets to make a large contribution, it can do so tax advantageously. This could be an excellent exit strategy for business owners/directors.

The SLA will increase each year on a predetermined basis from £1.5 million in 2006/2007 up to £1.8 million in 2010/2011. From 2011/2012 tax year I assume the SLA will continue to increase in line with the Retail Price Index, but no details are known at present.

After A-Day you can claim your pension on your 50th birthday (minimum retirement age) and still continue to work. What this means is that individuals will have greater scope to 'phase in' retirement by easing back on the number of hours worked and starting to take retirement income. This was restricted under the old (pre Apr 06) occupational rules. In 2010, the minimum retirement age will increase to 55, except for retirement due to ill-health. However you must take your pension by your 75th birthday, although there will be a new form of pension, known as Alternatively Secured Income, which will allow those who do not wish to purchase an annuity to avoid doing so.

After A-Day the tax free lump sum for a Defined Benefit (DB) scheme will be 25% of the benefit value within the Statutory Lifetime Allowance (SLA), if the scheme permits this. However, if your tax free lump sum before A-Day is higher than 25% of the value of your pension, this tax free cash pot is protected. Please note, if this sum is over £375,000 you will need to submit a claim for protection to the Inland Revenue.

Incidentally, if you wish to test the value of your pension against the SLA before you start to receive it, you multiply your annual gross pension, net of the tax free lump sum by 20 and then add the tax free lump sum to the answer. This gives you the value of your benefit which is then tested against the SLA. If this value is under £1.5 million you are within the SLA limit.

If the value of your benefit is over the SLA of £1.5 million, for example £2 million, the excess £500,000 can be taken as a lump sum which will be taxable at 55% (£275,000 tax liability). Alternatively, the excess can be used to provide a pension and in this instance a 25% tax charge would be applied to the excess first. Please note; your pension income is also taxable.

For those in danger of exceeding the SLA, or for those who already have benefit values in excess of the SLA at A-Day, there are ways of avoiding the tax charges by choosing either 'primary' or 'enhanced' protection.

From 6 April 2006 any 'death in service' lump sum payment will be tested against the SLA of £1.5 million. If the benefit is over £1.5 million the excess will be taxed at 55%.

After A-Day, if your pension benefit is shared on divorce, the pension value given to your ex-spouse will count towards their SLA. Only your share of the pension value will count towards your SLA.

Bob Fraser MBE, MBA, FPFS, TEP is a Chartered Financial Planner with Towry Law. He can be contacted on 0845 0850 530 or 07769 880476.

Bob Fraser
January 2006

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