Pension tax relief: How the lower allowances may affect you

Money Talk by Stephen Green
Towers Watson

Image caption,
You might need a calculator to work out how the pension changes affect you

How did the Autumn Statement cut pensions tax relief for higher earners?

The lifetime allowance restricts the tax-advantaged pension savings that an individual can accumulate over their career and the limit has been cut from £1.5m to £1.25 m.

The annual allowance limits the amount of tax-advantaged pension saving an individual can do in one year, and this has been cut from £50,000 to £40,000.

Both changes take effect from 2014-15.

Both allowances cover pension contributions or benefit promises financed by employers, as well as money that individuals save directly. Exceeding them can lead to tax penalties.

How to check

If you are saving only in defined contribution pension schemes, money paid into your pension pots over the year should be added up and compared with the annual allowance.

Remember to include any tax relief added separately by HM Revenue & Customs (HMRC).

Where employers promise "defined benefit" pensions linked to salary, things are more complicated.

If you are on a good wage and have been in one of these schemes for a long time, a pay rise could take you over the annual allowance and potentially land you with an unexpected tax bill.

To check, you take the annual pension you had built up by the start of the year and multiply this by 16.

You then adjust this for inflation, and then subtract it from the equivalent number 12 months later. The answer is compared with the annual allowance.

Baffled? Here is an example

Let's assume that a company pension scheme provides 1/60th of final salary for each year of service.

After 33 years' service, an employee earns £80,000. In their 34th year, they get a 5% pay rise, taking their salary to £84,000.

The calculation goes like this.

At the start of the year, they had accrued a pension of 33/60 x £80,000, or £44,000.

Multiply this by 16 and the pension entitlement is valued by the taxman at £704,000. Adjusting for 2% inflation increases this to £718,080.

At the end of year, the accrued pension is £84,000 x 34/60, or £47,560. Multiply this by 16 and the pension entitlement is valued at £761,600.

So the value of the accrued pension entitlement has risen by £43,520, which is more than the forthcoming £40,000 annual allowance.

You only have one annual allowance to share across schemes if you are in more than one scheme during the year.

What happens next?

If you think you might breach the annual allowance, you should look at whether you used up the full allowance in each of the three previous years.

Unused allowances can be "carried forward" and used to mop up this year's excess savings and avoid a penalty tax charge.

Any remaining surplus will however be taxed at your highest rate.

For example, if a 45% taxpayer saves £6,000 too much, they will have to pay £2,700.

If faced with a charge above £2,000, you will probably be able to instruct your pension scheme to pay it for you and deduct the money from your benefits.

How does the lifetime allowance work?

With defined contribution pensions, the size of the pot is measured against the lifetime allowance at the point of retirement.

With defined benefit pensions (typically final-salary schemes), any lump sum you take is measured at face value and the remaining annual pension multiplied by 20.

What this means is that the maximum defined benefit pension that can be accommodated within a £1.25m lifetime allowance is £62,500, or less if you also want a lump sum.

Pensions are only measured against the lifetime allowance at the time they come into payment.

Once the whole lifetime allowance has been used up, a penalty is levied on the remaining benefits when brought into payment.

You can either take the excess as a capital sum and pay 55% of it to HMRC, or hand over 25% and convert the remaining sum into a taxable income.

What if I have already saved too much?

People whose existing pension savings are worth more than £1.25m can keep the current £1.5m lifetime allowance, if they agree to stop all further pension saving from April 2014.

So can people who think their existing funds will exceed £1.25m once investment growth has worked its magic.

Other protection options are currently being explored by HM Treasury.

£1.25m sounds huge. Do I need to worry?

For most people a pension pot worth £1.25 million remains an unattainable sum.

However, the government has not budgeted for increasing this limit with inflation any time soon.

Just growing with inflation could take some large pension pots over the line in due course.

Should I curtail my pension savings?

One or both of the charges on "surplus" pension fund savings can outweigh the tax advantages of additional pension contributions, but that does not mean they should be avoided at all costs.

If your pension benefits are largely financed by your employer, and no cash alternative is on the table, you may still be better off building up the pension and paying the tax.

What else should I check?

It is important to note that the period over which your pension savings are measured might not match the tax year.

This can mean that the £40,000 annual allowance affects savings you make before April 2014.

If you think you might be close to the annual allowance, ask your pension scheme what measurement period, the so-called "pension input period", it has chosen.

This is a simplified summary of how these rules operate.

More information is available from HMRC.

The opinions expressed are those of the author and are not held by the BBC unless specifically stated. The material is for general information only and does not constitute investment, tax, legal or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Links to external sites are for information only and do not constitute endorsement. Always obtain independent, professional advice for your own particular situation.

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