2009 saw a major change in pension tax law with the arrival of the special annual allowance, restricting higher rate tax relief on some pension contributions. This was announced in the 2009 Budget and then amended less than eight months later at the time of the 2009 Pre-Budget Report. The result is something of a mess, not helped by the fact that the special annual allowance itself was due to be replaced from April 2011 by the 'high income excess relief charge'.

To this complex pension scenario Mr Osborne added some proposals of his own:

Pension contribution tax relief

For 2010/11, the December 2009 variant special annual allowance regime remains in force. As a reminder, the special annual allowance will only affect you in the current tax year if:

• Your 'relevant income' is £130,000 or over in the current tax year or either of the two preceding tax years;
  and
• You increase your 'normal regular ongoing pension savings'
  and
• Your 'total pension savings' during a tax year exceed your special annual allowance, which is normally £20,000, but can be up to £30,000.

'Relevant income' is defined as your total income less normal deductions (other than the personal allowance) and reliefs (eg trading losses) and Gift Aid, but with any deduction for pension contributions made personally limited to a maximum of £20,000 gross.

'Normal regular ongoing contributions' to a pension arrangement are:

For money purchase schemes, such as personal pensions

• The total annual amount of all contributions to the arrangement, provided that the contributions were made at least quarterly before 22 April 2009. This deadline is extended to 9 December 2009 if your relevant income was at least £130,000 but less than £150,000 in 2009/10 or either of the two preceding tax years;
  plus
• Any increase in your regular contributions that was agreed before 22 April 2009/9 December 2009.
  
  For an individual pension arrangement, such as a personal pension, a 'normal regular ongoing contribution' must be made to the existing (pre-22 April 2009/9 December 2009) arrangement. If you keep the total level of your total regular contributions the same, but pay them to different arrangements, then such contributions count as 'normal regular ongoing contributions' only in limited circumstances.
  
  The requirement that money purchase scheme contributions are made quarterly or more frequently means that no account is taken of annual payments in determining regular contributions. However, they (and one-off lump sums) can impact on the level of the special annual allowance.

For defined benefit arrangements, e.g. final salary pension schemes

• All your pension savings (which are measured by reference to the change in value of your accrued benefits from one tax year's end to the next). This is subject to the proviso that the way your benefits are calculated under the scheme rules does not change on or after 22 April 2009/9 December 2009, except in certain limited circumstances.

'Total pension savings' are all of your pension savings (from whatever source) that receive UK tax relief, including employer contributions. The pension savings value placed on your benefit accrual under a final salary scheme is 10 times the increase in pension plus any increase in a separate cash lump sum. For example, an extra £5,000 pension accrual is deemed to be £50,000 of pension savings.

'Special annual allowance' is the greater of:

• £20,000
  and
• The total over 2006/07, 2007/08 and 2008/09 of any infrequent (ie. less than quarterly) money purchase contributions, divided by 3. This annual average is subject to a maximum of £30,000.

The special annual allowance is therefore a minimum of £20,000 and a maximum of £30,000.

If you are caught by the special annual allowance rules, then, subject to the normal tax relief rules:

• You will receive full tax relief on your 'normal regular ongoing contributions';
• You will not be taxed on your employer's or any third party contributions;
  but
• Any additional pension contributions (from whatever source) or the value of any additional benefit accrual will effectively be restricted to basic rate relief to the extent that your 'total pension savings' in the tax year exceed the greater of your special annual allowance and your 'normal regular ongoing contributions'. This means a claw back of between 20% and 30% for 2010/11 contributions, depending on your level of income.

If you are not caught by the special annual allowance charge, 2010/11 is set to be the last opportunity that you have to benefit from the current annual allowance, which can permit pension contributions of up to £255,000 to be made for your benefit without any tax penalties.

The complex special annual allowance rules will finish at the end of 2010/11 and were due to be replaced by new measures legislated for in the pre-Election Finance Act 2010. The present rules protect existing regular contributions and allow full tax relief for at least £20,000 of contributions in 2010/11 whereas the Finance Act 2010 regime would have scaled back relief on all contributions if you fell within it.

The Chancellor had been heavily lobbied to rethink the Finance Act 2010 rules, which pension experts saw as overly complex, costly to administer and liable to further reduce employer interest in pension provision. However, the Liberal Democrats' manifesto proposed the complete abolition of higher rate relief, which the party said would save £5.5bn a year. Mr Osborne chose a compromise course which had been suggested by a number of pension experts: from 2011/12 the amount of the annual allowance will be reduced substantially and the Finance At 2010 legislation scrapped.

What the annual allowance reduction will be and how the replacement rules will apply are not yet known. The Chancellor has made clear that he does not want to lose any of the tax revenue which the previous measures would have produced. The Budget Red Book says 'Provisional analysis suggests that an annual allowance in the range of £30,000 to £45,000 would raise the necessary yield'. Relying upon the annual allowance to limit higher/additional rate tax relief means that the complex income thresholds planned for the high income excess relief charge will disappear, but the corollary is that the new limit will apply to everyone, not just the highest earners.

The Special Annual Allowance Charge in 2010/11 High income, no special annual allowance charge Ann has gross income of £138,000 in 2010/11 and made an individual pension contribution of £10,000, to which her employer added another £35,000. Her gross income in earlier years was under £130,000. Although her gross income exceeds the £130,000 threshold in 2010/11, her ‘relevant income' is under £130,000 after deduction of her £10,000 pension contribution, so Ann is not subject to the special annual allowance tax charge. However, a similar total contribution in 2011/12 could mean she falls foul of the new rules, depending upon their final structure. High income, special annual allowance charge David has ‘relevant income' of £145,000 in 2010/11 and has a self-invested personal pension to which total pension contributions of £40,000 were made by himself and his employer. The contributions were David's regular monthly contribution of £2,000 (as in the previous four years) and a single employer payment of £16,000. In the previous four years the employer had made one-off contributions of no more than £15,000 a year. David's ‘relevant income' exceeds the £130,000 threshold and his special annual allowance is £20,000. David's ‘total pension savings' thus exceed his special annual allowance. His ‘normal regular ongoing contributions' of £24,000 are not subject to any charge, but the additional employer contribution of £16,000 will be subject to a special annual allowance tax charge of £3,200 (£16,000 x 20%). David will pay this via his 2010/11 self assessment tax return on 31 January 2012. It might have been wiser to delay the employer contribution to 2011/12, depending upon how the new rules pan out. High income, special annual allowance charge Eric has ‘relevant income' of £250,000 in 2010/11, of which only £42,000 is earned income. He has a personal pension to which he has regularly contributed £500 a month. In 2010/11 he makes an additional contribution to the plan of £26,000. This is his first additional contribution since 2005/06. Eric's income exceeds the £130,000 threshold. His special annual allowance is £20,000, as he made no one-off payments in 2006/07-2008/09. Therefore his ‘total pension savings' are more than his special annual allowance. His ‘normal regular ongoing contributions' of £6,000 are not subject to the special annual allowance charge. However, the additional single contribution brings his ‘total pension savings' up to £32,000 and £12,000 of this (£26,000 + £6,000 - £20,000) will be subject to a special annual allowance tax charge of £3,600 (£12,000 x 30%). If Eric had limited his additional contribution to £14,000 he would have avoided the tax charge. Eric might also have gained from delaying £12,000 of his contribution to 2011/12, depending upon the new rules.

Annuities and age 75

The simplified (sic) pension tax regime introduced in April 2006 removed the previous requirement that for personal pensions and other money purchase pension schemes an annuity had to be purchased by age 75 at the latest. However, the non-annuity option, the alternatively secured pension (ASP) is so unattractive and the death benefits so highly taxed that it has seen little take up. In practice buying an annuity by age 75 has remained a de facto requirement. Indeed, the Coalition Agreement said ‘We will end the rules requiring compulsory annuitisation at 75'.

Mr Osborne has now put that pledge into being, albeit on an interim basis. Age 75 has effectively been replaced by age 77 while consultation takes place and the appropriate new legislation is drawn up for 2011/12. In the meantime, for money purchase pension scheme members who reach age 75 on or after 22 June 2010:

• If they are already using income drawdown, they can continue to draw income without having to apply the ASP income limits until their 77th birthday.
• If they have not started to draw benefits from an arrangement, immediately before reaching age 75, they will become entitled to income withdrawal and a (tax free) pension commencement lump sum. Thus it will remain the case that the lump sum must be drawn before age 75.
• On death after age 75, a 35% flat tax charge will apply to lump sum death benefits rather than the ASP provisions, which can result in a total tax charge of 82% of the residual pension fund.

It is unclear what the exact position is or will be for those people who started drawing income via ASP before 22 June 2010.

State Pensions

There were three important announcements on state pensions:

• In 2011/12 the basic state pension will be increased by the greater of RPI inflation, earnings increases and 2.5%, as promised in the Coalition Agreement. From 2012/13 onwards CPI inflation will replace RPI inflation in this ‘triple lock' formula.
• For other state pensions (eg state second pension and graduated pension), from 2011/12 annual increases will be based on the CPI, not the RPI currently used. This potentially means increases will be reduced by slightly below 1% a year based on the gap between CPI and RPI inflation since January 2000.
• The state pension age will be raised to 66, as promised in the Coalition Agreement. This will follow consultation and is likely to be from 2016 for men and 2020 for women.

Default retirement age

As promised in the Coalition Agreement, the Government also plans to ‘quickly phase out the Default Retirement Age from April 2011' so that employees can continue to work beyond age 65.

PLANNING POINTS

Beating the 2010/11 Special Annual Allowance Charge

The special annual allowance charge can never apply if your ‘relevant income' (see above) for the current and two preceding tax years is under £130,000. If your relevant income is below the £130,000 threshold for 2008/09 and 2009/10, then it could pay you to keep your ‘relevant income' down in 2010/11 if you want to make substantial pension contributions. Stay below the £130,000 threshold and there is no risk of losing higher rate tax relief.

There are a number of ways you can limit your ‘relevant income', for example:

• Personally making pension contributions of up to £20,000. These can be deducted when calculating relevant income, so can be useful if you are on the margins of being caught.
• Transferring income-generating assets to your spouse. Such transfers would be beneficial, even if you both pay higher rate tax. They may even help you reclaim your personal allowance if your income exceeds £100,000.
• Restructuring investments to produce less taxable income.
• Making Gift Aid contributions.
• If you are self-employed, taking advantage of the £100,000 annual investment allowance to buy plant and machinery, possibly bringing forward planned investments from later years.

Beating the 2011/12 Annual Allowance Charge

The special annual allowance charge cannot apply if you are not caught by the ‘relevant income' test described above. However, the planned move to a lower annual allowance – probably £45,000 at most – will affect you if contributions made by you or on your behalf exceed the new threshold, regardless of your income. Any contributions exceeding the annual allowance will be subject to the annual allowance charge, currently set at 40%, but probably rising to 50% in 2011/12.

For example, if you escape the special annual allowance charge, in theory during 2010/11 pension contributions of up to £255,000 (the current annual allowance) could be made by you and your employer without any tax penalty arising. From 2011/12 the penalty-free limit will be less than a fifth as much.

This window of opportunity could be particularly important if the planned contribution is an ‘in specie' transfer of valuable assets, eg a personal portfolio of investments or property owned by your employer. This is an area which requires expert advice: you should not make any move until the outline of the new rules has been published.

Drawing retirement benefits

If you are near to the point of drawing benefits from your pension arrangements, the change to the annuitisation rules has added another layer of complexity to your decision:

• Before June 22, the nearer you were to age 75, the more sense it made to opt for an annuity because once 75 was reached there was no real alternative.
• 77 has now replaced 75 on an interim basis, but it is not clear what the final structure will be:
• It is possible that there will be a new annuity-or-ASP age of, say, 80. The older you are, the higher the income an annuity can guarantee relative to income withdrawals. By 80, that gap is significant. The Coalition Agreement pledge was only to end compulsory annuitisation at age 75, not to stop it completely.
• The Chancellor might decide that beyond a certain age an inheritance tax charge should apply in addition to the 35% tax charge on lump sum death benefits, making an effective total tax charge of up to 61%. Under the previous government the Treasury was very wary of pension monies being used for any purpose other than the provision of retirement benefits. The Treasury's argument was that the tax paid on retirement income was the quid pro quo for tax relief on contributions.

The best course of action may be to delay drawing benefits until details of the new regime emerge. If that is not possible, then where death benefits are a potentially important factor, choosing drawdown would keep your options open. Buy an annuity today and you cannot change your mind afterwards.

<< BACK

This news item is provided strictly for general consideration only and is based on our understanding of law and HM Revenue & Customs practice as at July 2008. No action must be taken or refrained from based on its contents alone. Accordingly no responsibility can be assumed for any loss occasioned in connection with the content hereof and any such action or inaction. Professional advice is necessary for every case.

Burley Financial Services Ltd is a private limited company registered in England and Wales under company no. 121 7536.
Burley Financial Services Ltd is authorised and regulated by the Financial Services Authority.
We are entered on the FSA Register no 125891 at www.fsa.gov.uk/register