Finding your way out of a taxing problem
UK tax and pension rules are complex and this system has been tinkered with almost continuously over the last ten years or so.
The speed of change has increased dramatically over the last 12 to 18 months with changes introduced by the previous Government being superseded before they have even come into force. The latest changes – being brought forward by the new coalition Government - will affect how you save for your retirement in future, and how and when you take your retirement benefits.
For private pension provision, the previous Government had decided that high earners - broadly speaking those with taxable income of £150,000 or more – would only receive tax relief on pension contributions at the basic rate of 20% from April 2011 onwards. In other words to get £100 in your pension would cost you £80, with the Government adding an extra £20. This was a fundamental change to the traditional position where people got tax relief at their highest marginal rate (previously a higher rate taxpayer had to pay £60 to get £100 in their pot). While these changes would have raised additional tax revenue for Government, they were exceptionally complex to explain to customers and imposed onerous and costly administration duties on pension schemes and providers. This led to pension providers, politicians, employers and pensioner groups arguing strongly in favour of more simplistic changes.
Following the Emergency Budget at the end of June, the new coalition Government is going to replace these provisions, instead reducing what is known as the ‘annual allowance’. This will be introduced from April 2011, meaning the previous Government’s complex rules will never see the light of day. The annual allowance is the maximum payment people can make to their pension in a tax efficient way each year. The Government has said the reduced figure will be in the range of £30,000 to £45,000 each year, with initial views suggesting it will be £40,000.
If this is taken forward, from April 2011 you would be able to pay up to £40,000 each year into your pension and receive tax relief. It’s not yet clear if very high earners would get 50% tax relief (since April 2010 people pay 50% income tax on the slice of income above £150,000), or whether this will be restricted to 40% tax relief. Even in the latter scenario, a £40,000 pension contribution would effectively cost you £24,000, meaning pensions continue to be the most efficient tax regime up to this level of payment. If 50% tax relief is given, it would only cost you £20,000 to get £40,000 into your pension pot.
If you have previously paid higher one-off amounts into your pension occasionally, rather than making regular payments, these proposals mean you may need to change your behaviour by making smaller pension payments on a more regular basis.
The new Government is also suggesting some significant changes to how pension benefits are taken when people reach later life. Currently people are pushed towards buying an annuity by age 75, as the tax charges for those who die after 75 without buying an annuity can reach a staggering 82%. An annuity is where you give your pension fund to a provider who in return pays you a certain level of income for the rest of your life. This income may be level or increases each year, and it may continue to be paid to your husband or wife (or civil partner) after you die.
As an interim measure the Government has increased the cut-off age to 77, and is proposing to abolish the rules which require annuity purchase from April 2011 onwards. This means you can continue to take an income from your pension fund as long as you wish, with no need to buy an annuity. There is an upper limit on the income you can withdraw, which is broadly equivalent to the annuity you could buy. While annuities will still be popular with many people, as they provide a guaranteed income for life, others prefer to keep control of their own pension pot and these new rules will allow people to do that much more effectively.
The Government is also proposing a new option which may give you even more flexibility to take your pension benefits when it suits you. This suggestion would allow you to take an income above the current maximum limit, as long as you have a certain level of ‘secure’ income in your retirement. This would potentially allow you to withdraw all of your fund in one go, or withdraw a large amount at a time of your choosing. While you will pay income tax on the withdrawals, you may value this flexibility which could, for example, help you buy a new property, pay for long-term care, pass onto children or grandchildren or fund other tax-efficient investments.
The level of ‘secure’ income you would need before you can take advantage of this flexibility is likely to be around £12,000 to £15,000 per year. This can include state pension benefits, income from defined benefit pension schemes and annuities, but not other sources of income such as dividends which the Government don’t believe are ‘secure’ – in other words this income stream could disappear. The Government will only offer flexibility to people who have a secure income stream so it is confident that people won’t squander their pension pot, then fall back on state means-tested benefits.
The Government is also suggesting that the tax charge on death once you have taken your pension benefits, or once you are past age 75, will be 55%. While this is significantly lower than the current 82% charge that is levied if you die after age 75, I believe it is still too high. The Government is currently asking for views on these proposals and this is one aspect that Standard Life will ask the Government to change.
But, overall, I believe the new coalition Government is suggesting positive changes. Scrapping the horribly complex rules which were going to be introduced from April 2011 is a positive step. And an ability to pay £40,000 into your pension each year in a tax-efficient way is a simple measure that allows most people to save at a reasonable level. Removing the need to buy an annuity will also be welcomed by many people. While annuities are a valuable solution, especially for lower earners, other people want the ability to retain control of their own pension pot, increasing and reducing income to fit their needs, and leaving any remaining pot to family (less a reasonable level of tax charge).
Both the change to a £40,000 payment and the removal of the age 75 annuity requirement are the subject of a consultation process, but I’m encouraged by this ambitious pension reform agenda. With some further refinement it will hopefully help break down barriers to long-term saving, and make it easier for you to save in a tax efficient way, and access your retirement savings when it suits you to do so.
Tax and legislation are liable to change. This information is based on Standard Life’s current understanding of law and HM Revenue & Customs practice.
Tax rates and reliefs may be altered. The value of tax reliefs to the investor depends on their financial circumstances. No guarantees are given regarding the effectiveness of any arrangements entered into on the basis of these comments.