Whenever changes to the tax system are made, concerns about potential loopholes are never far away. Ever since the new pension freedoms were announced in March, people have warned they could lead to tax-planning opportunities. These enable National Insurance contributions to be avoided where salary is sacrificed to a pension or cash to be ‘recycled’, by putting it into a pension that attracts tax relief and taking up to 25 per cent of it tax-free.
Some in the industry feel widespread abuse of the system was never going to happen and did not want the Government to undermine the new flexibility by creating anti-abuse measures that were the proverbial sledgehammer to crack a nut.
Clarity has now been provided by the Government. It intends to introduce a new £10,000 annual allowance for those who draw more than their tax-free cash from a defined contribution scheme of more than £10,000 from April 2015.
But has it chosen the right course? For some, the £10,000 annual allowance will be a reduction from existing levels – the lower of 100 per cent of relevant earnings or £40,000. But the full annual allowance will remain for people who do not access their retirement pot and for those who cash in three pots up to £10,000 each or unlimited small occupational pots.
The Government’s reasons for the £10,000 annual allowance are to limit the potential for abuse while allowing people in drawdown to continue funding their pensions and benefit from tax relief on those contributions. This is in contrast to the current flexible drawdown rules, where the right to receive tax relief on further pension contributions is lost.
The reduced annual allowance makes sense to Axa Wealth head of technical consultancy Andy Zanelli. He says: “If you don’t control the input and you say that people over 55 have the same annual allowance as pre-55, you open up opportunities, with potential ways for people to recycle the cash so they flip the money and make a return.”
Zanelli says if the Government had replicated the current flexible drawdown rules by keeping an annual allowance of zero for people drawing down their pension from April, it would have been unfair on people who continue to work, in the light of auto-enrolment. It would also affect those who divorce later in life.
“That would be significant for someone over 60 who had to refund the pension they had to split on divorce,” he says.
Zanelli thinks leaving the allowance at 100 per cent of relevant earnings would have been too generous. “Something like £10,000 allows you to be part of auto-enrolment and you’re not going to get many people abusing the system,” he says.
Lorica Wealth Management chief executive Rhys Francis highlights a problem in having a £10,000 annual allowance running alongside the full allowance.
He says: “A lower annual allowance for people who have commenced drawing their pension may reduce the amount sacrificed by the over-55s. It would also require employers and providers to administer two different limits for two groups.”
Standard Life head of workplace strategy Jamie Jenkins believes the £10,000 annual allowance is a practical move by the Government.
He says: “The £10,000 annual contribution limit is significantly higher than most people who are automatically enrolled will pay. Few people will be impacted.”
Saltydog Investor founder and chairman Douglas Chadwick says if the flexibility does not work out as planned, there is nothing stopping the Government changing its mind. “It could change the tax you pay when drawing your pension, the tax-free allowance, and put back in controls restricting how quickly you can diminish your capital,” he says.
SG Wealth Management director Neil Shillito fears the flexibility could gradually be watered down and points to pension simplification as an example. “There have been a number of changes since then and it’s been difficult to understand what you can and cannot do,” he says.
One anomaly that could remain despite the £10,000 annual allowance is when a non-working individual over 55 invests the maximum contribution of £2,880. They would receive tax relief at source, grossing the contribution up to £3,600. Taking all the benefits under the flexible drawdown rules each year as a non-taxpayer then reinvesting £2,880 in the next tax year, they would benefit from £720 tax relief each year.
But Jackson Stephen Wealth Management partner Phil Newton thinks this would get picked up by HM Revenue & Customs. “Also, you have to factor in the costs of setting up a new plan every year. At present the only plan that can facilitate the proposed legislation is a Sipp, and while online versions are low cost, they aren’t entirely free.”