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Relief roads

Clerical Medical retirement planning manager Steve Meredith aims to steer employers and employees in the right direction over the relationship between pension contributions and tax relief after A-Day next year

There is as much confusion about what contributions can be paid to a pension after A-Day as there is regarding the tax relief that can be claimed.

Very simply, there will be no limit on how much an employer or employee can contribute to pension plans from April 6, 2006 – the only restriction is on how much tax relief they will receive.

As far as the member is concerned, a contribution will get tax relief if it is what is known as a relievable contribution. For a contrib- ution to be regarded as relievable, it cannot be more than 3,600 or 100 per cent of the member’s earnings, whichever is greater.

The pension provider will claim basic-rate tax relief on the amount paid up to this level. Higher-rate tax relief will have to be claimed through the member’s self-assessment tax return.

The confusion arises when a contribution is above the annual allowance (215,000 for 2006/07). If a pension has an input of more than the annual allowance, the Revenue will apply a tax charge of 40 per cent on the member to recover what it regards as excess tax relief. Although a contribution which is more than the annual allowance may suffer an excess charge, the contribution is still a relievable contribution if it is not more than 100 per cent of the member’s earnings.

Consideration also has to be taken of any employer contribution which pushes the total pension input above the annual allowance, as the member will be liable to 40 per cent tax on any excess.

The two examples (right) illustrate how the new rules on contributions and tax relief will work in two different situations.

Much has also been written about the annual allowance being ignored in the final year of vesting and many individuals are understandably interested in using this rule to maximise their contributions just before retiring. However, it is worth noting that although contributions can exceed the annual allowance without a punitive charge, the member will still need to have earnings to justify a relievable contribution.

Going back to Tony in our first example, he can make a 234,000 net contribution and both he and the provider can claim tax relief. But if Tony vests all his benefits in the scheme in the same year, the Revenue will not apply a 40 per cent charge on a contribution above the annual allowance because the annual allowance is ignored.

In the second example, Paula can pay a contribution of 200,000 in the year she vests her benefits but she will still only receive tax relief on an amount up to 100 per cent of her earnings (100,000) at her marginal rate. This is because it is the annual allowance that is ignored, not the rules regarding relievable contributions.

For both examples, if the employer makes a big contribution of say, 300,000 in the final year of vesting, there will be no tax charge on the employee because the annual allowance in the year that benefits are vested is ignored.

It can be seen that it will probably not make sense to exceed the Revenue’s limits because there will be no tax relief on any contribution over 100 per cent of earnings and 75 per cent of the resulting fund will be taxable on vesting. Furthermore, it is likely that some providers will only accept contributions which are relievable.

In the second example, Paula may find that her provider only accepts 78,000 of her 200,000 intended contribution.

Although an employer will be allowed to pay unlimited contributions, it is important to be aware that the employer’s contributions must be “wholly and exclusively” for the purposes of running the business to be eligible for tax relief.

In practice, this means that the local inspector of taxes will have discretion to decide whether the employer’s contributions are reasonable, given the circumstances. The inspector of taxes will take into account the salary and dividends that the employee receives, the type of work they do and what that is worth to the business.

It may well be the case that the employer will not obtain tax relief on a contribution of, say, 215,000 for an employee who is paid 5,000 a year. But even if the employer does not obtain tax relief, the employer contribution will still be taken into account when considering the pension input.

The Revenue has confirmed that it will be issuing detailed guidance for the local inspectors of taxes to ensure a consistent approach in decisions. We look forward to reading these when they become available.

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