The 3.8bn giveaway
The well publicised 2p cut in the basic rate of income tax has a less-publicised knock-on effect on the basic rate of tax relief on pensions.
The reduction in basic rate tax relief on pensions from 22 per cent to 20 per cent affects all basic-rate taxpayers and non-taxpayers. If all adults in this group paid the 3,600 that they are entitled to contribute to a pension this year (and those with earnings above 3,600 can contribute more), this would result in a staggering 41.4bn of tax relief.
However, overnight on April 5, that amount will drop by 3.8bn. Advisers should discuss with their clients whether they would like a piece of this great tax giveaway before the opportunity is taken away forever.
Higher-rate taxpayers may be surprised to know they too could be affected.
Depending on the amount they earn above the income tax thresholds, they may see the tax relief available to their pension reduce. Those contributing to personal pension schemes will receive 2 per cent less tax relief at source, although they can claim higher rate tax relief in their annual tax return up to 40 per cent. Determining contribution strategy for clients in order to optimise tax relief is paramount.
Irrespective of the tax relief available, it is clear that many clients are not making the most of the annual allowance. According to a recent survey of 500 advisers, 65 per cent of advisers say three-quarters of their clients are only paying up to 10 per cent of their earnings each year.
For some clients, this will be suitable but there may be others who are in a position to make the most of the tax relief and other benefits offered by pensions but perhaps have not thought to do so.
For example, it may be worth discussing the options with those members of the baby boomer generation with sums of money to invest.
Given the current age distribution in the UK, advisers are likely to have many clients in this age profile. It is also likely that many of these have not yet made adequate provision for their retirement as another survey of 1,641 consumers in their 50s and 60s showed that two out of three people had not started looking into financial plans for retirement until after their 50th birthday.
It is not too late for those clients who did not start planning in their 20s, 30s or 40s. It may be useful to provide an illustration to clients. For example, assuming an investment growing at 7 per cent a year with an annual charge of 1.5 per cent, if a higher-rate taxpayer invests 20,000 into a pension at 50, by the time they reach 65 their fund could be worth 73,312.
In contrast, if they wait until they are 60 and start the pension with the same amount, the fund might only be worth 43,348 at 65. When it comes to the annual allowance, the phrase use it or lose it has never rung so true.
It is also worth remembering that there is no annual allowance restriction for the tax year in which people retire, so at that stage the sky is the limit when it comes to contributions.
Pension input periods
There are also the fortunate clients with earnings that are greater than the annual allowance of 225,000 for this tax year to consider.
Although the normal relief restriction on pension contributions is to the lower of 225,000 and 100 per cent of net relevant earnings for a pension year, there is a legitimate way to contribute more than this in a tax year.
This works by an adjustment to the date at which the contribution period ends and careful planning is needed.
A date within the current pension input period and ending in the current tax year is nominated as a new end to the pension year.
This means the client can make full use of this year’s annual allowance during the current pension input period. It also has the effect of bringing forward the following pension input period, which will end in the 2008/09 tax year.
This accelerates the use of next year’s annual allowance and allows a second payment to be made in this tax year, which will be subject to tax relief. That way, more tax relief can be claimed than would be the case by spreading the payment of contributions over two tax years.
The point may be best illustrated by an example. Consider Mr A who earns 500,000 this tax year. He has already made a contribution of 225,000 to a pension. His pension input period is scheduled to end on April 5, 2008 but his adviser requests to reset it to end on March 5, 2008 so that his new pension input period ends on March 5, 2009 in the 2009/10 tax year.
Mr A then makes another contribution of 235,000 on March 20, 2008. This is counted against the new pension input period but has still been made in the 2007/8 tax year. Careful consideration is required to ensure the correct tax outcome is achieved for clients based on their specific circumstances.
One final point that is one of the most significant benefits of pensions but all too easily overlooked – tax relief. It may seem so obvious that it does not need to be said but there is evidence that it does.
A 2007 survey of 1,000 people aged 22-64 found that only 43 per cent were aware that pensions are subject to tax relief.
It is also worth reminding clients that all adults can benefit from it but the basic rate of tax relief is about to go down, so more is available now than will be from April 6. This brings us back to the first point, the deadline is approaching fast so when it comes to pensions – use it or lose it.