Money tip #32 – Pay into a pension
Pensions offer a tax efficient way to invest for your retirement. Not only do the funds within a pension grow free of any income or capital gains tax but any contributions you make into the plan receive income tax relief at your highest marginal rate.
So in simple terms if a basic rate tax payer pays £80 into his pension the tax-man tops this up to £100. Similarly for a 40% rate tax payer a £100 contribution into his pension fund actually only costs him £60. However, while this seems a great deal, which it is, the trade of is that you won’t be able to access your pension fund until you are 55 and even then only 25% of it can be taken as a tax free lump sum. The rest has to be used to provide you with a retirement income.
Sounds great but how much can I pay into my pension each year?
You can pay as much as you like into your pension schemes. However, you’ll only get tax relief on up to the lower of 100% of your earnings or the annual limit (currently £245,000) if you are a UK taxpayer. So if, for example, you earn £50,000 but put £60,000 into your pension scheme, you will only get tax relief on £50,000.
The annual limit is set by HM Revenue and Customs and changes each year. Any contributions you make over this limit will be subject to an annual allowance tax charge which is currently 40%.
The good news is that even non-earners can pay into a pension and receive tax relief on their contributions. Non-earners can pay £2,880 each tax year and have this topped up to £3,600 by the tax man.
So as long as I keep my contribution within those limits can I build up as big a pension pot as I want?
The answer is both yes and no. There is a lifetime allowance which limits the amount you can accumulate free of tax in all your pension funds when you come to draw your benefits. This is £1.8m for the tax year 2010/11. You have to pay tax on any excess over the £1.8m allowance. Salary-related pension scheme benefits are given a value which counts towards the £1.8m lifetime allowance. Any amount above the lifetime allowance can be paid as a pension benefit but is subject to tax of up to 55%. You may still have to pay tax on your income when you start to draw the pension.
But in any event given that pension income is taxable it is debatable whether there is much merit in building a fund which would give rise to a pension in excess of the basic rate tax band particularly if you only received basics rate tax relief on contributions on the way in.
But I am a high earner and have heard that there are new limits on what I can put into pensions, is that true?
That is partly right. While you can still put contribute up to the previously mentioned limits, the level of tax relief you will get may be restricted as a result of the anti-forestalling provisions announced in the 2009 Budget. Grant Thornton have summarised things beautifully on their website so rather that reinvent the wheel take it away Grant Thornton..............
What are the anti-forestalling provisions?
The anti-forestalling provisions were introduced as a means of preventing taxpayers from making artificially large pension contributions prior to 6 April 2011 in order to benefit from relief at 40% (or 50% from April 2010), before the rate of relief for higher earners is restricted from 6 April 2011.
The amount of relief available will now be tapered for individuals with income between £150,000 and £180,000, from 50% (the new higher rate tax rate for individuals earning over £150,000) down to 20%, with only basic rate relief available where income exceeds £180,000. The anti-forestalling rules will apply to those individuals who are treated as having 'relevant income' of £150,000 or more. Relevant income includes total income before personal allowances, pension contributions, other reliefs and deductions but after normal deductions and reliefs, e.g. trading losses, pension contributions up to a maximum of £20,000, and gift aid. The relevant income for the two previous tax years also is taken into account. For example, if your relevant income was less than £150,000 in 2009-10, you could still be subject to the restricted relief for that year if your relevant income was £150,000 or more in 2007-08 and/or 2008-09.
Any income sacrificed for pension contributions, as part of a salary sacrifice arrangement entered into after 22 April 2009 will also have to be added back in order to arrive at relevant income when looking at the £150,000 threshold.
In addition, a person is treated as having relevant income of £150,000 or more if there is a scheme the main purpose, or one of the main purposes, of which is to secure that the individual’s relevant income for the tax year is less than £150,000. (source Grant Thornton tax specialists).
What is the issue the amendment sought to alleviate?
Where regular pension contributions continue as previously made, the provisions do not take effect. Similarly, where 'excess' contribution made do not exceed £20,000, there will be no restriction of relief. Where contributions do exceed £20,000 there will be a 20% tax charge in 2009/10 to clawback the relief received at 40%.
However, the rules as originally proposed only recognised contributions as regular where they were made quarterly or more frequently. This definition was decried as discriminatory against, for example, the self-employed who will often make annual contributions once their profits for any given year have been established.
What has changed?
The 2009 Finance Bill is now at the Report Stage, and last week the Government tabled some amendments to the law, which were accepted.
The amendments insert a new paragraph 16A into the legislation which allows for infrequent contributions. The average of contributions made in the three tax years from 2006/07 to 2008/09 is taken, which is defined as the 'relevant mean'. If the contributions in those three tax years have exceeded the annual allowance for pensions (£215,000 in 2006/07, £225,000 for 2007/08 and £235,000 for 2008/09), the contributions will be treated as being equal to the annual allowance.
Where the relevant mean exceeds the £20,000 limit, as above, for infrequent contributions only, the limit below which relief is not restricted is extended to £30,000, or the amount of the relevant mean, if lower.
This means that those making infrequent contributions will now be able to benefit from full relief to the lower of £30,000 and the average contributions, instead of the £20,000 for those making more frequent regular contributions.
So to sum up
Pensions offer a tax efficient way to save for your retirement particularly as you get tax relief on any contributions. But a pension vehicle such as a Self Invested Personal Pension (SIPP) could also be used to shelter any gains or income from your portfolio of investments from the tax man. By simply holding the assets within the SIPP wrapper as opposed to outside you could avoid paying tax on all future gains.
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