Higher-Rate Tax Relief on Pension Contributions
Good News for Your Pension Pot
GOOD NEWS for anyone wanting to save for retirement: Higher-rate tax relief on pension contributions is here to stay (at least until the next general election anyway).
Higher-rate tax relief means you effectively receive a refund of ALL the income tax payable on the top part of your income equal to the level of your pension contributions.
The previous Labour Government decided to withdraw higher-rate tax relief from those with income over £150,000. Once your income reached £180,000 you would only receive basic-rate tax relief – i.e. an effective refund of the first 20% tax only.
Some nasty penalties were also introduced to stop high earners making big pension contributions before the April 2011 implementation date. These so-called ‘anti-forestalling’ provisions ended up sucking in even those with income of £130,000 and are so hideously complex that many pension experts do not understand them.
After the general election in May 2010, there were fresh fears that the new coalition Government would go one step further and scrap higher-rate tax relief for EVERYBODY.
This, after all, was a Liberal Democrat election pledge, made in the interests of ‘fairness’, that word so loved by politicians these days.
In October 2010, after spending several months consulting industry experts, the Government finally released its proposals to change pension tax relief. These will be welcomed by most readers.
For starters, both the Labour and Liberal Democrat proposals have been placed in that special Round File – i.e. the dustbin.
Higher-rate tax relief on pension contributions will not be taken away from anyone and those who earn over £150,000 will have their full tax relief restored.
Better still, because taxpayers who earn over £150,000 pay 50% income tax, they will enjoy 50% tax relief on their pension contributions.
We know this because the Government has announced that: “Tax relief will be available at an individual’s marginal rate.”
Your marginal tax rate is usually 20%, 40% or 50%, depending on the level of your taxable income. It could even be 60% if you earn between £100,000 and £112,950 (the income band which sees your personal allowance withdrawn).
Contribution Limits - So what’s the catch?
The Government has decided to reduce the amount you can contribute to a pension plan each year. Fortunately, the proposed contribution limits are reasonably generous.
From 6th April 2011 the maximum contribution on which you can receive tax relief will be £50,000 per year. The original consultation document talked about a maximum of between £30,000 and £45,000.
£50,000 is a lot less than the current maximum of £255,000 but, in practice, that limit has been pretty meaningless for the last couple of years anyway because of the anti-forestalling provisions.
Note that £50,000 is the maximum gross pension contribution you will be able to make and includes the basic-rate tax relief which the taxman pays into your pension pot. The maximum cash contribution an individual can make will therefore be £40,000.
All of the contributions paid by an employee and his or her employer are counted when calculating if the limit has been exceeded.
If your pension contributions exceed the annual allowance you will have to pay a tax charge on the excess at 20%, 40%, or 50% – i.e. your marginal tax rate.
Even More Good News
The new rules contain some extra flexibility that will be warmly welcomed by business owners and others who like to vary their pension contributions from year to year.
If you want to contribute more than £50,000 during any given tax year, you will be able to tap any unused allowance from the three previous tax years. So you could potentially make a pension contribution of up to almost £200,000 and enjoy full tax relief.
Paula is a sole trader and makes bumper profits during the 2011/12 tax year. She decides to make a pension contribution of £100,000.
Paula’s pension contributions in each of the three previous tax years were £20,000, meaning that she has £30,000 of unused allowance in each year, giving £90,000 in total.
Together with the £50,000 annual allowance for the 2011/12 tax year, Paula can therefore claim tax relief on a pension contribution of up to £140,000. This means her £100,000 contribution will enjoy full tax relief.
You will use the annual allowance for the current tax year first. You will then use your unused annual allowance from earlier years, using the earliest tax year first.
This leaves any unused allowance from the most recent tax years free to be carried forward. In Paula’s case she will be able to carry forward £10,000 of unused allowance from 2009/10 and £30,000 from 2010/11.
There is one important catch, however. The draft legislation states that:
Unused annual allowance is only available for carry forward where it arises during a tax year in which the individual is a member of a registered pension scheme but applies to a tax year even if the pension input amount for that year is nil.
What this seems to imply is that if you start contributing to a pension in 2011/12 but did not belong to a pension scheme in the three previous tax years, your pension contributions will be limited to £50,000.
In the guidance on its website HMRC seems to be interpreting the draft legislation differently, saying that: “If you have not made pension savings for an earlier year then you will not have an annual allowance for that year to carry forward”. This implies that you have to belong to a pension scheme AND make contributions if you want to carry forward any unused annual allowance, even though the draft legislation specifically states that contributions are not required.
We will have to wait for further clarification but, to be on the safe side, it may be worth making small contributions before 6th April 2011 in order to ensure that this year’s unused allowance is available to carry forward.
There was also an announcement concerning the so-called ‘lifetime allowance’ – the maximum pension pot you can build up during your lifetime. This will be reduced from £1.8 million to £1.5 million.
Again, most taxpayers will not lose any sleep over this restriction.
Most readers will find that they are still able to save as much as they would have liked in their pension plan and continue enjoying the maximum tax relief. Those with fluctuating income levels may need to ensure they make the most of their unused annual allowances in previous years, so a bit of planning over the timing of their contributions could pay off.
Defined Benefit Pension Schemes
There is some concern amongst members of defined benefit schemes that the reduction in the annual allowance from £255,000 to £50,000 may result in unexpected tax charges, especially in years in which a big salary increase is received. The new three-year carry back rule addresses most of these concerns.