Fundamental changes are coming into effect from April and advisers need to make sure their clients are taking the appropriate action.
The two most significant changes are the pension tax rules and the way in which money can be withdrawn once people reach retirement.
There are three main changes to pension tax – the introduction of a reduced annual allowance of £50,000, the ability to carry forward any unused relief to the following three years and a reduced lifetime allowance of £1.5m.
While the reduction in the annual allowance sounds bad news, it is an improvement for most of the people who can afford to pay big contributions.
The current temporary anti-forestalling rules limit the amount high earners – those with taxable income of £130,000 or more – can pay to pensions, often to £20,000 a year.
Even better, there is a new rule allowing people to carry forward any unused allowance from the previous three tax years.
This is retrospective, meaning those whose contributions were restricted to £20,000 because of anti-forestalling rules in 2009/10 and 2010/11 will be able to carry forward £60,000 or more in addition to their £50,000 annual allowance for 2011/12.
Those in defined-benefit schemes are more likely to face a tax charge in future as a notional contribution is calculated based on the increase in the value of the benefits over the year.
A new valuation factor of 16 – much higher than the current factor of 10 – is used. Among the lucky few still building up benefits in a DB scheme, high earners and those with long service who get sizeable salary increases are most likely to face the largest tax bills.
Where contributions exceed the allowable amount (after taking carry forward into account), the tax charge will be calculated by adding the excess contribution to other taxable income via self-assessment, with a 40 per cent or 50 per cent tax charge likely to follow for most. The first £2,000 of any tax charge must be paid by the individual directly. For any tax above this level, people can ask the scheme to pay the bill, with a
corresponding reduction in the benefits which will be paid from the scheme.
One issue which moves to centre stage as a result of these changes is pension input periods. When measuring pension payments against the annual allowance, it is the total payments in the input period ending in the tax year which count, not the payments made during the tax year. This is particularly important as we move from the £255,000 annual allowance to the new £50,000 annual allowance.
A payment of £100,000 today may sound fine as it is within the £255,000 allowance but a tax bill may arise unless the input period is closed by April 5, 2011. If the input period ends next tax year, then the £50,000 allowance applies, even if the payment is made today. An input period can be closed by notifying the pension provider. However, as only one input period can end in any one tax year for each arrangement, retrospective changes may need to be made in some situations.
The lifetime allowance will reduce from £1.8m to £1.5m in April 2012. Those with funds above £1.5m or who think their funds may exceed £1.5m in future, will be able to claim a personal lifetime allowance of £1.8m as long as they stop building up benefits from April 6, 2012.
Claims for this new fixed protection must be made before April 6, 2012.
Those who claimed enhanced or primary protection as a result of the simplification changes in 2006 are unaffected.
Aside from pension tax changes, the existing age 75 rules are to be scrapped. In future, there will be no requirement to take income or tax-free cash at age 75 and the need for the much maligned alternatively secured pension will disappear. In its place, income drawdown will run from age 55 to death, with maximum income withdrawals limited to 100 per cent of the basis amount laid down in new GAD tables.
The new income limits take effect from April for new entrants to drawdown. For existing drawdown customers, income will continue for the remainder of their five-year review period, after which income will be recalculated based on the new rules.
There is a last-ditch opportunity to move a nominal amount into drawdown to “reserve” the ability to take 120 per cent income for the next five years, even on money moved into drawdown after April 2011. This is only available via some providers, so check first.
Currently, death benefits before age 75 (once benefits are in payment) will result in a 35 per cent tax charge.
After age 75, the total tax bill can potentially reach 82 per cent. Under the new rules, there will be a single charge of 55 per cent – once benefits are in payment or once an individual passes age 75. And pension funds will now be free of inheritance tax in almost all instances.
A new facility called flexible drawdown will allow people to take income above the normal maximum as long as the individual has “secure” income of at least £20,000 a year. Only guaranteed lifetime income counts, including state pensions, scheme pensions and pension annuities.
Withdrawals will be taxed as income and any amount withdrawn will immediately become liable to inheritance tax unless gifted away, so advice is vital.
While stripping out your whole pension fund may sound appealing, paying income tax at 50 per cent and IHT at 40 per cent is much worse that leaving it in the pension.
So it may make sense to keep money to pass to the next generation within a pension wrapper.
John Lawson is head of pensions policy at Standard Life