Pensions ‘A’ day

The new pensions regime, originally announced in December 2002, will finally take effect in April 2006. From that date there will be a single set of tax rules for all registered pension schemes.

The key points of the new regime are as follows:

• a single, lifetime limit on the amount of pension saving that can benefit from tax relief, initially to be set at £1.5 million and rising to £1.8 million by 2010;
• any excess over the lifetime limit to be subject to a 25% ‘recovery’ charge;
• pension funds in excess of the lifetime limit may be withdrawn entirely as a lump sum subject to a higher recovery charge of 55%;
• an annual allowance (the maximum contribution qualifying for tax relief in a tax year) of £215,000 rising to £255,000 by 2010;
• individuals will be entitled to tax relief on personal contributions in any given tax year up to the higher of 100% of relevant earnings or £3,600;
• an increase in the age at which pensions can be drawn to 55 by 2010.

Where an individual has pension rights valued in excess of £1.5 million when the new rules are introduced, this value can be protected together with any growth up to the RPI. Alternatively individuals who plan to cease contributions to all pension schemes by April 2006 can register for ‘enhanced’ protection thereby avoiding the recovery charge altogether.

Details of the new rules are as follows:

Registration

Pension schemes will still need to register under the new regime to benefit from privileged tax treatment, ie exemption from tax on income and gains within the fund and eligibility for tax relief on contributions to the fund.

Any scheme that is already registered when the new rules are introduced will be treated as registered under the new regime unless it chooses to opt out.

Relief for individuals’ contributions

Under the new regime, there will be no restriction on the amount of contributions an individual can pay into a registered scheme, only on the amount of tax relief given. This means that unlimited contributions may be made to, and retained by, a registered pension scheme. Investment income build-up and capital gains will accrue tax-free within the fund.

An individual will be entitled to tax relief on personal contributions in any given tax year up to the higher of 100% of ‘relevant UK earnings’ (broadly employment income or trading profit).

Methods of giving relief

Tax relief on contributions will continue at the individual’s marginal rate of tax.

Under the existing regime an individual may obtain tax relief on personal contributions he makes to an approved scheme in one of three ways:

• under relief at source for contributions to a personal pension (including stakeholder) with higher rate relief claimed through the self assessment system;
• under the net pay system where contributions are made to an approved retirement benefits scheme or a relevant statutory scheme;
• by making a claim to relief where contributions are made to a retirement annuity contract.

These three methods will continue to operate under the new regime.

Employer contributions

Under the simplified regime there will be a single rule for allowing a deduction in respect of employer contributions to a registered pension scheme. They provide for a deduction for unlimited sums subject to the contributions actually being paid in the period and paid ‘wholly and exclusively’ for the purpose of the business.

Statutory spreading provisions are introduced for exceptionally large employer contributions. A contribution will only be spread where it is more than 210% of the contribution paid in the previous period and the amount of the excess is at least £500,000.

Annual allowance

Despite there being no limits on contributions that can be paid into registered schemes under the new regime, the annual allowance will act as a control.

The annual allowance provides for the annual increase in an individual’s rights under all registered pension schemes to be calculated. This is then compared with the annual allowance and any excess charged to income tax at 40%.

For 2006/07 the annual allowance will be set at £215,000.

In order to lessen the effect of the annual allowance when someone is close to retirement, it will not be applied in any year in which the benefit is taken in full.

Example

Jo is a shareholder/director in his family company. He draws an annual salary of £5,000 and takes significant dividends out of the company.

He has a self invested personal pension (SIPP). Under the new regime, Jo would be able to pay an annual contribution of £5,000 (gross) (with tax relief) into his SIPP.

The company may be able to make unlimited contributions but to the extent they exceed £210,000 (ie £215,000 annual allowance less the £5,000 Jo has paid) Jo will suffer a 40% tax charge on the excess.

In order for the company to obtain tax relief, the contribution needs to satisfy the ‘wholly and exclusively’ test.

Lifetime allowance

The second key control under the new regime will be the lifetime allowance.

Although individuals can save as much as they like in registered schemes under the new regime, when they start to draw benefits (a ‘benefit crystallisation event’) the value of their fund will be tested against the lifetime allowance and any excess subject to the lifetime allowance charge.

There are eight different benefit crystallisation events. They cover:

• the different ways an individual can begin to take a pension;
• the receipt of a lump sum in connection with a pension;
• the receipt of certain lump sums paid out in connection with the death of the individual; and
• the transfer of funds from registered schemes to certain overseas pension schemes.

On the first benefit crystallisation event the calculation will be straightforward, a comparison between the value being attributed to the event and the then lifetime allowance. Where there has already been an event, the calculation is more complex. The value of the first benefit crystallisation event is uprated by the proportionate increase in the standard lifetime allowance and this uprated figure, referred to as the ‘previously used amount’, is compared to the individual’s lifetime allowance at the second date. Any excess lifetime allowance is available to be used against the new benefit crystallisation event.

After much debate, the lifetime allowance has been set as follows:

2006/07 - £1.5 million
2007/08 - £1.6 million
2008/09 - £1.65 million
2009/10 - £1.75 million
2010/11 - £1.8 million

Thereafter the limit will be reviewed every five years.

Where funds in excess of the lifetime allowance are be taken as a lump sum the rate of charge is 55%. The lifetime allowance charge rate on the balance of funds in excess of the lifetime allowance has been set at 25%.

Protection from the lifetime allowance charge

Two types of protection are available.

Primary protection

Protection will be given to the value of pre A-day pension rights and benefits in excess of £1.5 million. The pre A-day value will be indexed in line with the indexation of the statutory lifetime allowance up to the date that benefits are taken.

Enhanced protection

This is available whatever the value of the fund so long as active membership of approved pension schemes ceases before A-day. Provided that active membership is not resumed all benefits coming into payment after A-day will normally be exempt from the lifetime allowance charge.

This is likely to be beneficial for those with funds in excess of £1.5 million by April 2006 and for those with funds below that level but who expect investment growth well above inflation.

Example

Those requiring protection will have three years from A-day to register.

Scheme benefits

Under the new regime, up to 25% of the pension fund, below the lifetime allowance, can be paid as a tax-free lump sum. For many people, particularly those in schemes where the lump sum is currently capped, this represents a significant increase.

However, subject to the lump sum, the balance of the fund must be secured by age 75 using one of:

• a pension - guaranteed by an insurance company (ie an annuity);
• a pension - promised by an employer; or
• alternatively secured income (ASI) where security is gained by reducing the maximum income that can be taken.

If death occurs before the pension vests it can be paid to dependants as a lump sum subject to the lifetime allowance charge, if relevant, or as pension income subject to income tax.

Investments

There will be a single set of investment rules under the new regime. Broadly pension schemes will be allowed to hold all types of investment subject to some restrictions which are mentioned below.
There will be limits on holdings of shares in the sponsoring employer’s company (of 5% of the fund value) and on loans to employers.

Loans to employers must:

• be secured as a first charge on assets;
• have an interest rate at least equal to the CTSA rate (currently base rate + 1%);
• not last for more than five years;
• not be more than 50% of the value of the fund at the date the loan is taken out; and
• be repaid by equal annual instalments.

Scheme borrowing will be limited to 50% of scheme assets at the date the loan is taken out.

However, from ‘A’ day the government have announced that they will remove the tax advantages for investing in residential property or certain other assets such as fine wines, classic cars and art and antiques from pension schemes which are ‘self-directed’. This will include Self Invested Personal Pension Schemes (SIPPS) and Small Self Administered Schemes (SSAS). The effect will be to remove all tax advantages from holding prohibited assets directly or indirectly in such schemes and will broadly mean that it is at least no more advantageous to hold such assets in a pension scheme than it is to hold them personally.

How We Can Help

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