Taxation of Pensions

Simplifying the taxation of pensions: increasing choice and flexibility for all…

After detailed consultations during 2002 and 2003, the Chancellor included significant changes to pensions legislation within the Finance Act 2004. These include legislation which, whilst introducing a welcome simplification of pensions, also has some ominous implications for individuals with larger pension funds; particularly those with a Small Self Administered Scheme (SSAS), a Self Invested Personal Pension (SIPP) or a Funded Unapproved Retirement Benefit Scheme (FURBS). Moreover, many of the proposals appear to be retrospective.

In this factsheet, we cover the main issues but it should be noted that, although the legislation has been published there are a number of points yet to be clarified. We do, however, have a detailed understanding of the proposals to date as we have examined the legislation and consultation papers and have made representations to the Government in the interests of our clients.

Summary of main proposals

The eight different regimes currently in force for company pension schemes and personal pension plans will be removed and replaced by a single new set of rules. These new rules will apply from a date known as "A Day", which is proposed as the 6 April 2006.
Under the proposed system, each individual will have a Lifetime Allowance of £1.5 million for the amount of pension savings eligible for favourable tax treatment. The Allowance is based on the value of a member's pension fund at retirement (benefit crystallisation) rather than contributions. There is provision for the limit to increase each year.
The concept of the tax-free cash sum will remain. The cash lump sum limit will become a straightforward 25% of the fund up to the Lifetime Allowance.
If total retirement benefits are above the Lifetime Allowance, then any excess will be subject to a Lifetime Allowance Charge of 25%. It will be possible to take the remaining excess fund either as taxed income or as a taxed lump sum.
The entitlements of existing pension scheme members to both pension and lump sum as at "A Day" will be protected.
The minimum early retirement age will increase from 50 to 55, by 2010.
Individuals will be permitted to draw benefits while continuing to work for the same employer, thus removing the current "early retirement" problems.
A wider range of income options in retirement will be permitted, including more flexible annuities.
Member contributions will be unlimited but there will be an "Annual Allowance" for tax relief of the lower of £215,000 per annum or 100% of the earnings in that year (or £3,600 per annum if greater). Contributions may be paid up to age 75.
Individuals will continue to receive tax relief on their contributions at their marginal rate of income tax up to the above allowances.
Investment rules within pension arrangements are to become the same for all types of scheme and will be significantly widened.

There is, of course, much greater detail within the legislation which cannot be covered here but we indicate, below, some of the issues which may need serious consideration.

Contributions

The maximum personal contribution eligible for tax relief will be 100% of earnings subject to an upper limit of £215,000 (2006/07 tax year. In addition, unlimited employer contributions are proposed and would usually attract corporation tax relief in the year of payment. However, employer contributions in excess of £215,000 per year (or an increase in pension of £21,500 for Defined Benefit schemes, based on the proposed 10:1 commutation factor) will be taxed on the employee at 40%. In the year of actual retirement there is no limit on contributions eligible for tax relief.

In most cases, these new rules will result in greater contributions being possible than under current regimes. If, however, existing arrangements allow contributions above these limits, this right will be lost. If, under present legislation, a contribution above this limit can be paid, it may be worth exploring the possibility of making such a contribution prior to A-Day.

Retirement benefit

All arrangements will have the same maximum benefit rules. At retirement 25% of the fund can be taken as a lump sum. The remaining fund must then be used to produce an income, which will be taxed at marginal rates.

These rules will apply to all pension funds within the new "Lifetime Allowance" of £1.5m (increasing to £1.8m by 2010). If a member's funds exceed this limit then the excess will be subject to a "Lifetime Allowance Charge" of 25%.

All benefits from the excess fund will be taxed, but would be available as a lump sum taxed at a further 40%. A higher rate tax payer will, therefore, pay an effective tax rate of 55% on all funds in excess of the Lifetime Allowance.

Within these overall benefit rules, it will still be possible for schemes to have different benefit structures. For instance, a Defined Benefit (or Final Salary) scheme can still exist and provide guaranteed benefits. The values of these benefits will, however, be monitored against the Lifetime Allowance and the fund will be taxed where benefits exceed the Allowance at retirement. There are to be standard commutation factors.

Flexibility in retirement

The standard minimum age at which retirement benefits may be taken will increase to 55 by 2010. Benefits must commence by age 75.

Until age 75, pension benefits may be unsecured and paid from the scheme subject to the following:

Maximum income of 120% of the single life level annuity rate applicable, reviewed at least every 5 years.
No minimum income (subject to any Department for Work and Pensions requirement).

Pension benefits must be secured at age 75 by one of the following:

an annuity
alternatively secured pension (ASP) which is an alternative to a traditional annuity.

Transitional Protection

Transitional protection is available for those with pre A-Day rights which would be affected by the new limits. Members seeking to protect existing rights that might exceed the £1.5m lifetime allowance will have 3 years from A-Day in which to register their pre A-Day rights.

Primary Protection - registered pre A-Day rights will be treated as a personal lifetime allowance, which is then increased in parallel to the increases in the Lifetime Allowance up to the date benefits are taken. This protects the existing funds from the recovery charge although it could be applied to future fund growth and to future contributions.
Enhanced Protection - this will be available to individuals who cease active membership in all pension arrangements before A-Day, provided they do not resume membership of any registered scheme. All benefits coming into payment after A-Day will normally be exempt from the Lifetime Allowance Charge.
Tax-Free Cash - can also be protected where it is from an occupational pension scheme and the level payable is greater than 25%. This is, however, scheme specific and the protection will be lost on subsequent transfer.

The transitional arrangements are complex and therefore advice should be taken.

Investments

The Government intends to apply a single set of investment requirements to all pension schemes, and in particular to apply the same rules to SSAS and SIPPS. The proposals include limits on the holdings of shares in sponsoring employer (up to 5%) and limits on loans to employers.

The range of investments allowable within pension funds will be expanded. This will continue to include commercial property but will also include residential property. However, the amount that can be borrowed by a pension plan, to allow such an investment, will be subject to tighter limits.

Any new rules will apply to new investments and there will be transitional rules to protect schemes from having to make urgent disposals of assets which are incompatible with the new rules.

The effect of simplification

The Treasury has indicated that the aim of the legislation is to simplify the rules applying to all pension arrangements. In doing so, they hope to increase the benefits available for the majority. They do, however, accept that a number of individuals will have their benefits reduced from the levels that they previously anticipated. This means that, for some individuals they may need to maximise their pension provision before "A-Day" to take best advantage of the present legislation.

Who should I contact?

It is imperative that everyone reviews their pension arrangements and considers the potential effects of this legislation. In order to establish the practical implications for yourself or your business, please contact the person at Grant Thornton who normally deals with your tax or financial planning affairs, or the local office below.

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