PENSION SIMPLIFICATION | TAG

PENSION SIMPLIFICATION

The 2004 Budget saw proposals to simplify Pension Legislation from 6 April 2006, thereafter known as A day.

This has resulted in the creation of a single regime to replace the existing eight tax regimes and the changes will affect those in occupational and personal pension schemes and employers.

The new regime introduces two new benefit and funding controls, the pension lifetime allowance and pension annual allowance, which replaces the existing web of rules and guidelines.

Other changes allow all schemes to offer tax free cash of up to 25% of the fund thus allowing employees the opportunity to continue working for their employer and take benefits from their company schemes.

Post A day pensions schemes are to be allowed to invest in a wider range of investments and the rather multifaceted approval process for pension schemes will be replaced with a simplified registration procedure.

Pre A-Day the eight different tax regimes each had their own complex set of rules that limited the amount an individual might contribute to their pension scheme as well as the benefits at retirement age. This resulted in differences in the contribution and benefit levels between defined benefit (final salary) schemes and defined contribution (money purchase) schemes.

Lifetime allowance

A standard lifetime allowance has been introduced and is the maximum amount of pension savings that can benefit from tax relief and this has been initially set at £1.5 million. This figure will rise over time and the proposed amounts are as follows:-

This new allowance is based on the approximate amount that would be required to purchase a pension equal to the maximum allowable under the tax regime. Any funds in excess of the lifetime allowance are considered to have benefited unfairly from tax advantages and therefore a tax charge is made.

In terms of occupational scheme benefits, HMRC have determined that the lifetime allowance is the amount required to provide maximum benefits for a 60 year old with earnings equivalent to the earnings cap of £105,600 in 2005/06.

HMRC use a factor of 20:1 for converting a defined benefit scheme to a cash equivalent. The £1.5 million lifetime allowance represents a gross income of £75,000 per annum.

Funds in excess of the lifetime allowance can be taken as a lump sum but would be subject to a tax charge of 55%. There is a charge of 25% on funds that exceed the allowance and are used to provide an income and the income would also be subject to income tax at the individuals marginal rate, which would be 40% resulting in an overall tax charge of 55%.

Annual Contribution Allowance

The annual allowance has been initially set at £215,000 and this figure will rise annually regularly as illustrated below until 2010 when the figure will be £255,000.

However, the limit will not apply in the actual year of retirement and it is therefore possible to make substantial contributions just before retirement to increase pension income.

The age and income related contributions for personal pensions has been replaced and individuals may make contributions subject only to the annual allowance.

Tax relief on contributions is limited to 100% of relevant earnings. Where funding exceeds the annual allowance a charge of 40% is levied on the excess contributions.

Where an individual has no earnings he or she may contribute up to £3,600 per annum (£2,808 net of basic rate tax) to a personal pension or stakeholder pension where tax relief is received at source.

Retiral Age

The minimum pension age is currently 50 years. For anyone not drawing benefits as at 6th April 2010 this will increase to 2010. This applies to taking the tax free lump sum, annuity purchase and income drawdown.

Between 6 April 2006 and 5 April 2010 it will be permissible for anyone over 50 years of age to take pension benefits. This also applies to existing pension arrangements that currently have a higher minimum retirement age, such as protected rights benefits, where the minimum age was previously 60.

From 6 April 2010 it will not be possible for individuals under the age of 55 to take pension benefits. The only exceptions are the following:

 

Trivial Pensions

Trivial pension rules aim to increase the number of options available where an individual has a smaller fund by taking this as a lump sum.  There are a number of conditions that the individual must comply with as follows:-

Pensions in payment may also be commuted but will be taxed in full as earned income.
From the amount commuted 25% can be taken as a tax free lump sum and the balance is taxed as earned income.  The following example shows the tax implications for a basic rate tax payer that has a fund of £15,000.

 

Where there is no trivial fund and earnings support a gross pension contribution of up to £15,000, an individual can make a single contribution to a pension prior to retirement. In the above example a payment of £11,700 would be required which benefits from tax relief at the outset so £15,000 is invested in the fund. The individual can immediately encash the fund under the trivial rules realising after tax a sum for £12,525 making a once only net profit of £825.

HMRC apply a penalty of up to £3,000 for those who negligently or fraudulently obtain any unauthorised payment. This includes trivial commutation payments when the value of benefits from all schemes exceeds the 1% limit.

Tax free lump sum

Pre A-Day the tax free cash entitlement from a pension differs between defined benefit and defined contribution schemes. Under the new rules all schemes will be able to pay a tax free lump sum of up to 25% of the fund value, up to the maximum of 25% of the lifetime allowance irrespective of the type of pension.

This includes protected rights or the protected rights element of a pension, AVCs, FSAVCs and transfers from occupational pension schemes.

For defined benefit schemes the scheme must calculate the value of the pension to determine the maximum tax free cash. The calculation used by the HMRC is a 20:1 value for converting a defined benefit scheme to cash. Therefore assuming a pension accrued of £20,000 per annum, this would represent a cash value of £400,000 which would produce a tax free cash sum of £100,000.

Where a scheme member had rights (pre A day) within an occupational pension scheme which entitled them to more than 25% tax free cash, these rights are automatically retained within the pension scheme and they will also be uplifted in line with the increase in the standard lifetime allowance.

Benefits accrued after 6 April 2006 must apply the 25.0% maximum tax free cash and this applies to all occupational pension schemes on transfer to another scheme irrespective of any retained rights.

Where the tax free lump sum exceeds 25% or more than £375,000 (25% of the £1.5 million lifetime allowance for 2006/07)) a tax charge will be made.

 

Value protection annuity

A feature of the pension annuity is the value protected annuity. This represents a return of original capital less annuity payments received in the event of the annuitant's death before the age of 75. The proceeds are payable less 35% tax.

Where an annuitant chooses a value protection annuity it will not be possible to add a guaranteed period. Because the value protection annuity is only available up to the age of 75, the longer the annuity purchase is deferred, the shorter the period of protection and this must be balanced with the benefits of a 10 year guaranteed period.

Term certain annuities

Where an individual is using income drawdown it is possible to purchase a term certain annuity for up to 5 years. The income provided by the term certain annuity counts towards the maximum income withdrawal allowable under income drawdown up to the age of 75. All term certain annuities must end by age 75.

Annuity guaranteed period

The current maximum period for a guarantee is 10 years and starts the same date the annuity starts in payment. Thus, in the event of an early death of the annuitant after say 5 years, a 10 year guarantee period will continue to pay the annuity for a further 5 years. Depending on the precise arrangement it is possible for this remaining income to be commuted to a lump sum instead.

Under pension simplification it would not be possible to commute to a lump sum, although the 10 year guaranteed period would remain.

Alternatively Secured Income (ASI)

The rules for ASI are detailed below; however, after yet another u turn by HM Chancellor of the Exchequer, it is now taxed so erroneously as to be most impractical but not quite obsolete.
After the age of 75 an alternatively secured income (ASI) would allow an individual withdrawal of income, similar to income drawdown.  An individual would switch from a pension plan to an alternatively secured pension (ASP) at that time.

ASI has been introduced in particular to assist those individuals with religious beliefs that prevent them from purchasing an annuity on ethical grounds.

The minimum ASI can be £0 per annum and the maximum is 70% of the Government Actuaries Department (GAD) annuity tables for an annuitant aged 75, and reviewed annually. This low limit to continue in drawing an income has been set to discourage people that have no religious reasons for not purchasing an annuity.

Where funds remain on death, in the first instance they must be used to provide pensions for dependants. If there are no dependants the funds can be transferred to a nominated charity or transferred to another member of the pension scheme. In either situation there would not be a tax liability.

AVCs

Post A-Day the rules permit a tax free lump sum of 25% to be taken from an AVC or FSAVC.
Pre A-Day there was no possibility for commutation to a tax free lump sum with an AVC started after 1987 or an FSAVC.  The entire fund had to be used to purchase an annuity providing an income at retirement age.

Income drawdown

Unsecured income drawn directly from the pension fund at or before retirement remains and there are changes making this arrangement more flexible. Pre A-Day the withdrawal amounts were limited by tables produced by the Government Actuaries Department (GAD) where the maximum income is 100% of a single life annuity and the minimum is 35% of the maximum.

Post A Day this is replaced by a simple formula allowing a minimum income withdrawal of £0 and a maximum of 120% of a single life annuity. This income amount is to be reviewed at least every 5 years.  This would also include any income drawn via a term certain annuity.

In the event of the death of a member prior to his/her 75th birthday the remaining fund would be paid to the beneficiaries less a 35% tax charge. After the age of 75 the individual must purchase a lifetime annuity or switch to an alternatively secured pension (ASP) if their circumstances allow it.