Pensions: no plain sailing but high earners could save tax from new reforms

The recent changes announced on pension allowances present chances for high earners to save tax, say financial planners.

Welcome back carry forward

We don’t yet know all the detail but one thing is certain, the changes made to pension allowances last week before the further changes in this week's spending review present some real opportunities for saving tax for high earners.

‘It is going to produce a deadline for next April and it will be very good for Sipps [self-invested personal pensions],’ said Geoffrey Pointon, chairman of pension consultants Pointon York.

One of the big opportunities is the ability to carry forward unused tax relief for up to three years. Few of us can afford to pay into a pension scheme the maximum allowed – even at the new reduced maximum of £50,000 a year. But the facility to carry forward unused tax relief presents some interesting planning opportunities, particularly for those with lump sums to invest.

From next April 2011, tax relief on pension contributions will be limited to 100% of earnings or £50,000 a year, whichever is the less. For those in a company scheme, contributions from both employee and employer are counted. If contributions are more than £50,000, the contribution is taxed at your highest marginal rate up to the maximum 50%.

But the ‘carry forward’ of unused tax relief will allow an individual who has perhaps cut back on pension contributions during the recession to make contributions to their pension up to £200,000 over any four year period – £50,000 for each of the previous three years and £50,000 for the current year.

‘The devil will be in the detail,’ said Keith Churchouse of Churchouse Financial Planning. ‘Clearly there will be one or two avenues for planning that will be left open.’ But that may be not for everyone. ‘I have two cases on my desk now where the individuals have pension funds of over a million and are up against the lifetime limit and they are just going to have to pay the 55% tax charge,’ Churchouse warned. ‘But don’t panic. We need the full details to see how things pan out.’

More 'simplification'

Currently the maximum pension pot or lifetime allowance is £1.8 million. From April 2012 it will be reduced to £1.5 million, although those currently over the £1.5 million limit will be able to protect their fund. The lifetime allowance takes into account the combined value of all personal as well as occupational pensions and will be frozen at £1.5 million until at least 2016 and then reviewed.

The new rules are meant to simplify pensions tax relief and the three-year ‘carry forward’ will replace the old rule which allowed you to contribute up to 100% of final year’s earnings to a pension scheme – with full tax relief. This ‘final year’ concession was superseded by former chancellor Alistair Darling’s changes in his last Budget which limited tax relief to those with earnings over £130,000.

From April of next year maximum tax relief will be 100% of earnings, or up to £200,000 (if you have full unused tax relief from the previous three years) – whichever is the less. So if you earn only £75,000 in your last year before retirement but happen to have  £100,000 of unused tax relief on pension contributions carried forward from earlier years, you will only get tax relief on contributions up to £75,000.

The new rules will also largely put a stop to the practice of directors in final salary pension schemes awarding themselves a huge pay rise in their final year of employment in order to boost their pension. ‘If you do this the deemed value of that is now very high,’ warned Laith Khalaf, pensions expert at Hargreaves Lansdown. ‘People in final salary schemes who award themselves large pay rises in their final year will potentially face big tax charges as the accrual rate has been raised from 10 to 16.’ 

What is the accrual rate?

The accrual rate is a complex calculation for assessing whether the value of a defined benefit, final salary pension contribution in terms of the extra pension it will earn is more than the new limit of £50,000 a year. The value of any increase will be multiplied by 16 instead of the old multiple of 10 to produce a  'notional contribution' rate which will be measured against the new £50,000 contribution limit.