David Harrowven explains pensions tax relief under the 2014 Finance Act
Studying this technical article and answering the related questions can count towards your verifiable CPD if you are following the unit route to CPD and the content is relevant to your learning and development needs. One hour of learning equates to one unit of CPD. We'd suggest that you use this as a guide when allocating yourself CPD units.
In April 2006 the pension scheme rules were simplified, with the same rules applying to both personal pension and occupational pension schemes.
Previously, different rules applied to each type of scheme, with the rules for personal pension scheme savings being particularly complicated. The amount of tax relief depended on a person’s age and earnings, and there was a six year carry forward of unused relief. Under the simplified rules any amount can be contributed into a pension scheme, with tax relief effectively being restricted to the lower of earnings and an annual allowance. The changes meant that people could contribute significantly more towards their retirement.
It was too good to last. After just three years the Labour Government announced that tax relief on pension savings was going to be restricted to the basic rate of 20% for high income individuals. The Coalition Government agreed that a reform of pensions tax relief was a necessary part of reducing the fiscal deficit, but took an entirely different approach.
The annual allowance for 2010-11 was £255,000, but for 2011-12 the Coalition Government reduced it to £50,000. The annual allowance remained at £50,000 for the next two years, but has been further reduced to £40,000 from 2014-15 onwards. However, pension savings made within the £40,000 limit continue to qualify for tax relief at a person’s highest marginal rate of tax, be it the basic rate of 20%, the higher rate of 40%, or the additional rate of 45%.
If the annual allowance is not fully used in any tax year then it is possible to carry forward any unused allowance for up to three years. Carry forward is only available if a person was a member of a pension scheme for a particular tax year. Therefore for any year in which a person was not a member of a pension scheme the annual allowance is lost. However, it is not necessary to be an active scheme member for a particular year, since the definition of a member includes a deferred member (someone not currently making or building up new pension savings) and a pensioner member (someone who is receiving their pension). The carry forward rules protect people, especially employees, who exceed the £40,000 annual limit due to a one-off ‘spike’ in pension savings.
The carry forward from the tax years 2011-12, 2012-13 and 2013-14 is based on the annual allowance of £50,000 applicable to each of those years. For example, a person has made pension savings of £42,000 for 2011-12, £38,000 for 2012-13, and £32,000 for 2013-14. There are unused allowances of £38,000 (£8,000 (£50,000 - £42,000) from 2011-12, £12,000 (£50,000 - £38,000) from 2012-13, and £18,000 (£50,000 - £32,000) from 2013-14), so with the annual allowance of £40,000 for 2014-15 it is possible to make pension savings of up to £78,000 (£40,000 + £38,000) for 2014-15. This is subject to having sufficient income to benefit from the relief.
The annual allowance for the current tax year is utilised first, and then any unused allowances from earlier years - with those from the earliest year used first. Therefore, if in the above example pension savings of £44,000 were made for 2014-15, the unused amount carried forward to 2015-16 would be £30,000. The annual allowance for 2014-15 is fully used, with the balance of £4,000 utilising some of the unused allowance for 2011-12. Therefore, the unused allowances of £12,000 for 2012-13 and £18,000 for 2013-14 are carried forward.
Pension input periods
The annual allowance is not measured against pension savings actually paid in a tax year, but is instead measured against the savings for a pension input period. These are normally 12 months long. A person may have more than one pension input period if they have several different pension arrangements. It is the pension input period ending within the tax year that is relevant. For example, a person’s pension scheme has an input period that ends on 30 November. For the tax year 2014-15 the relevant input period is that ending on 30 November 2014, and pension savings made during this period will be used to determine if the annual allowance for 2014-15 has been exceeded. However, it is the pension savings actually paid during the tax year (6 April 2014 to 5 April 2015) that will be used in calculating the tax liability for 2014-15.
For pension schemes commencing on or after 6 April 2011, these complex rules have been simplified because by default the first pension input period ends on 5 April. So if a person makes a pension contribution on 1 December 2014, the first pension input period will run from 1 December 2014 to 5 April 2015. Subsequent periods are then aligned with tax years. The 5 April default date applies unless an earlier or later date is nominated.
It is possible to change a pension input period provided the new period ends in the tax year following the tax year in which the previous period ended. This might be done to align the pension input period with the tax year, or to align pension input periods across several different pension schemes.
Pension input periods can sometimes be manipulated to increase the amount of pension savings qualifying for tax relief in a particular tax year. For example, a person makes a personal pension contribution of £40,000 on 1 December 2014, nominating a pension input period ending on 31 December 2014. The second input period will run from 1 January 2015 to 31 December 2015. A further pension contribution of £40,000 can then be paid during the period 1 January 2015 to 5 April 2015. Both contributions are paid during 2014-15, and will therefore qualify for tax relief in that year. However, for annual allowance purposes the first contribution falls into 2014-15 whilst the second falls into 2015-16.
For personal pensions and other defined contribution schemes the amount of pension saving for a particular pension input period is simply the gross amounts paid during that period, including any contribution from an employer.
For example, an employee with a salary of £200,000 contributes 4% into his employer’s defined contribution scheme. The employer contributes a further 6%. The pension savings are £20,000 (£200,000 x 10%) for each period.
For defined benefit schemes the rules are more complex. For a particular pension input period the amount of pension saving is found by comparing the notional capital value of the pension at the end of the period to what it was at the start of the period. A standard valuation factor of 16 is used in these calculations. The opening capital value is increased by the 12 month increase in the Consumer Price Index for the September prior to the tax year. The increase in value over the period is the amount of pension savings for that period.
For example, an employee is a member of a final salary scheme that will provide her with a pension of 1/60th of salary for each year of service. The pension input period is the 12 months to 31 December 2014. On 1 January 2014 the employee’s salary was £80,000 and she had 20 years of service. By 31 December 2014 her salary had increased to £84,000. The 12 month increase in the Consumer Price Index for September 2013 is 2.7%. The calculation is as follows:
Swipe to view table
|Notional capital value £80,000 x 20/60 x 16||426,667|
|Increase for Consumer Price Index at 2.7%
|Notional capital value £84,000 x 21/60 x 16||470,400|
For 2014-15, the employee’s pension savings for annual allowance purposes are therefore £32,213. This is much higher than the employee’s actual contributions (probably in the region of £5,000) qualifying for tax relief.
Annual allowance tax charge
Where pension savings are made in excess of the annual allowance (including any brought forward amount), then the surplus amount is subject to an annual allowance tax charge. This charge is at a person’s marginal rate of income tax.
For example, for 2014-15 a self-employed person has taxable income of £200,000. She paid gross personal pension contributions of £54,000 in respect of her pension input period ending on 5 April 2015, and no brought forward relief is available - so the surplus amount is £14,000 (£54,000 - £40,000). The higher rate band will be increased to £204,000 (£150,000 + £54,000), so £4,000 (£204,000 - £200,000) of the surplus amount is taxed at the higher rate of 40%, with the remainder taxed at the additional rate of 45%. Therefore the annual allowance tax charge will be £6,100 ((£4,000 at 40%) + (£10,000 at 45%)).
In this example the net effect is to remove the tax relief that should not have been given. However, because of the way in which pension input periods work, there may be a mismatch between the tax relief given on pension savings and the amount of relief subsequently removed by the annual allowance tax charge. For example, a pension contribution may result in tax relief of 45% in 2014-15 (if this is the year of payment), but the surplus amount may only be taxed at 40% in 2015-16 (if this is the year in which the pension input period ends).
The complicated pension input period rules mean that with an annual allowance of just £40,000 it is very easy for a person to inadvertently incur an annual allowance tax charge, especially where an employee changes employments. It may therefore be advisable where possible for a person to align their input period(s) with the tax year.
The lifetime allowance for 2014-15 is £1,250,000. This allowance applies to the total funds that can be built up within a person’s pension arrangements, and there will be a tax charge when that person subsequently withdraws the funds in the form of a pension if the limit is exceeded.
The Government estimated that the latest reduction in the level of annual allowance to £40,000 will have affected around 140,000 people. However, the lower level of annual allowance that has applied since 6 April 2011 does not affect anybody with annual pension savings below the limit regardless of their level of income.