Pension Schemes, Contributions and Tax Relief

6 April 2006 (known as 'A' Day) saw the introduction of unifying rules for all occupational and personal pension schemes that are registered as qualifying for tax relief.

Non–registered pension schemes continue, but without any tax advantages.

Contributions

Under the new rules there is no limit to the number of schemes an individual may belong to. Most of the contribution restrictions have been replaced by two overall key controls:

Annual allowance (AA)

Annual contributions up to the level of earnings (or £3,600 gross if greater) attract tax relief. Contributions above these levels will not receive any relief and there will be a tax charge to the extent that the increase in pensions savings in a tax year exceeds the AA (£40,000 for 2015-16).

Lifetime Allowance (LTA)

This is taken into account whenever benefits are withdrawn. At the first withdrawal, any funds used in excess of the LTA will be taxed at 25% to the extent that they are used to buy a pension or 55% in the case of lump sum payments. There have been many changes in the LTA since it was first introduced.

Scheme Investment

One of the features of the new system was the lifting of restrictions on types of investment, and it is possible for registered pension schemes to invest in more or less anything.

However, the Government has removed the tax advantages where self–directed pension schemes invest in residential property or certain other assets such as fine wines, classic cars and art & antiques. This is to prevent people benefiting from tax relief in relation to contributions made for the purpose of funding purchases of holiday or second homes and other prohibited assets for their or their family's personal use.

Borrowing by schemes to increase investments is limited to 50% of the fund.

Administration

The complex approval process for pension schemes has been replaced by a simplified regime requiring registration only. Schemes that were approved schemes before A–Day have automatically become registered schemes.

Transitional arrangements protect pre A–Day pension rights (including rights to lump sum payments).

Pension Contributions and Tax Relief

Scheme Members

Any member of a registered pension scheme may make unlimited contributions to a registered pension scheme. However to qualify for tax relief a contribution must be a relievable pension contribution made by a relevant UK individual.

Most member contributions are relievable, unless they fall into any of the following categories:

  • contributions after age 75
  • contributions paid by employers (see below)
  • age related rebates or minimum contributions by HM Revenue & Customs (HMRC) to a contracted–out pension scheme

A relevant UK individual is an individual who

  • has relevant UK earnings chargeable to income tax for that tax year
  • is resident in the UK at some time during the tax year
  • was resident in the UK at some time during the immediately preceding five tax years and also when joining the pension scheme

The maximum amount of contributions on which a member can claim relief is the greater of:

  • the basic amount (currently £3,600)
  • the amount of the individual's relevant UK earnings for the tax year

This means that a member who has no relevant UK earnings may still qualify for tax relief on contributions into a registered pension scheme up to the basic amount. The relief in these circumstances can be given only if the contribution is made to a scheme that operates the relief at source (RAS) system.  The relief is available even if the individual is a non–taxpayer.

A registered pension scheme must operate RAS unless the scheme rules specifically provide that it can operate net pay arrangements or accept contributions gross from members.  Under RAS, premiums are paid net of basic rate tax which is claimed back by the scheme administrator. Higher or additional rate relief can be claimed through the member's Self Assessment tax return.

With net pay arrangements, the employer deducts the relievable pension contribution from employment taxable income before operating PAYE (so tax relief is obtained by paying the contribution out of pre–tax income).  A member making payments in full (that is, out of after–tax income) has to claim the tax relief from HMRC, generally through the Self Assessment system or PAYE code.

If the total contributions result in the Annual allowance being exceeded, there might be a tax charge on the member (see below).

Employers

Any employer of a member of a registered pension scheme may make contributions to that registered pension scheme.  Unlike for scheme members, there is no set limit on the amount of tax relief that an employer may receive in respect of its contributions. Exceptionally large contributions will be spread over 2 to 4 years.

Other persons

A person other than a member or employer may make a contribution to a registered pension scheme in respect of a member of that scheme.  A person can be an individual, a corporate body or other legal entity.  Where the contribution is paid under RAS, it is only the member who may claim higher rate relief on the contribution.  Where a third party pays a RAS contribution, such contributions are treated as if made by the individual who is the member of the scheme, not the person who made the contribution. The contribution is paid net, and the basic rate tax is claimed by the scheme on behalf of the member, who can claim higher or additional rate relief in the normal way.

Annual allowance

The annual allowance (AA) is £40,000 with effect from 6 April 2014. AA is the amount by which the total pension savings can grow each year; above this value the surplus gives rise to an annual allowance charge as the individual's top slice of income.

Pension savings

Members of defined contribution (DC) schemes, in particular personal pensions (PPs), will need to look at the total of the contributions (whether personal, employer or third party) during the pension input period (PIP) for all of their pension savings. The PIP is usually the scheme year to the anniversary date which falls within the relevant tax year. Members of defined benefits (DB) schemes, such as occupational final salary schemes, will have to work out how much their accrued pension has increased during the PIP (see below for a worked example). Pension scheme administrators will be responsible for providing information to their members on their pensions savings for each tax year if those savings exceed the AA, or at the request of a member. All pension input periods will be concurrent with the tax year from 2016-17 onwards.

Defined benefit schemes

In defined benefit (DB) schemes, individuals accrue a right to an amount of annual pension from pension age. To treat DC and DB schemes in a comparable way, it is necessary to deem the value of notional contributions in a DB scheme. These notional contributions should reflect what would need to be invested in a DC scheme to deliver the extra annual pension accrued in a DB scheme.

However, the calculation needs to be as simple as possible so a 'flat factor' method is used. The Government has decided that the level of the factor will be set at 16 meaning, broadly, that an increase in annual pension benefit of £1,000 would be deemed to be worth £16,000.

Example: DB scheme

Nicole has been a member of her employer's DB scheme for 30 years. The scheme provides a pension of 1/60th pensionable pay for each year of service. In her 31st year, she receives a pay rise from £35,000 to £45,000.

Opening annual pension entitlement  30/60 x £35,000 =
£17,500
Closing annual pension entitlement 31/60 x £45,000 =
£23,250
Increase in annual pension entitlement  
£5,750
Deemed contribution 16 x £5,750 =  
92,000

So Nicole may have to pay an AA charge on the £52,000 surplus over the £40,000 limit, depending on whether carry forward relief is available. The contribution is relatively large in this example due to the combination of long service, a large pay rise and the decrease in the annual allowance.

If Nicole had left the scheme after 30 years, then the pension at the end of year 31 would have been uprated by the CPI. If the CPI increase is assumed to be 2.5%, then her pension earned after 31 years would have risen from £17,500 to £17,937, a deemed contribution of only £6,992 (16 x £437).

The rate of charge

The AA charge is due on any pension savings over and above the AA available for the year. The effect of the AA charge is to remove tax relief on any pension savings over the available AA and perhaps also to add a liability on employer contributions.

The amount you pay depends on the rate at which tax relief has effectively been given on the excess pension savings, which in turn depends on how much taxable income you have and the amount of your excess pension savings.

To find out the amount of your AA charge you add the amount of your excess pension savings to the amount of relevant income you actually pay tax on. The amount of pension saving:

  • over your higher rate limit will be taxed at 45%
  • over your basic rate limit but below your higher rate limit will be taxed at 40%
  • below your basic rate limit will be taxed at 20%

Example: Calculation of AA charge

John has £10,000 excess pension saving on which he has to pay the annual allowance charge. John also has £142,000 income that he has to pay tax on. The total of John's taxable income and excess pension saving is £152,000.

For the purpose of this example the higher rate limit is £150,000. The basic rate limit is £40,000. £2,000 of John's excess pension saving is above the £150,000 higher rate limit. £8,000 of his pension saving is above the basic rate limit but below the higher rate limit.

John's tax charge is calculated as:

£2,000 @ 45% = £900
£8,000 @ 40% = £3,200
AA charge = £4,100

Lifetime Allowance

The lifetime allowance, which sets the maximum figure for tax-relieved savings in the fund, will be reduced from £1.25 million to £1 million from 6 April 2016.

Where total pension savings exceed the lifetime allowance at retirement, a tax charge of up to 55% may apply. The lifetime allowance will be indexed annually in line with CPI from 6 April 2018.

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