The 2016/17 tax year will herald a ‘two pronged attack’ on the pensions of higher earners, with a couple of big changes taking effect; a reduction in the annual amount that higher earners will be able to save into pensions and claim tax relief on (the ‘annual allowance’), combined with a further reduction in the pension ‘lifetime allowance’ to £1 million.
The mechanisms of the changes are extremely complex and, as a result, the legislation that made them law has only very recently been granted Royal Assent. With just four months remaining until the changes take effect, those that will be affected by them should start planning immediately.
So what are the changes? How could they affect you? What can be done to mitigate their effects?
1. Reduced Annual Allowance for higher earners
Speculation has surrounded the future prospects of higher rate and additional higher rate tax relief on pension contributions for some time now. Rather than move to a flat rate of tax relief for all from 2016/17 onwards, George Osborne has instead opted to preserve tax relief at the highest marginal rates, but restrict pension contributions for those earning over £150,000 per year on a tapered basis – a reduction in annual allowance of £1 for each £2 of ‘adjusted income’ over £150,000 per year, as illustrated in the following table:
Those earning more than £210,000 gross p.a. will be restricted to a gross annual allowance of £10,000 from 2016/17 onwards, a reduction of £30,000.
In order to prevent the manipulation of incomes to avoid the £150,000 threshold, two separate methods of assessing income will be used; ‘adjusted income’ and ‘threshold income’.
• Adjusted income is total taxable gross income from all sources, including pension, savings, dividend and rental income and it also includes member (paid from gross salary) AND employer pension contributions.
• Threshold income is gross income (pre-salary sacrifice for arrangements set up after 8th July 2015), less allowable deductions, but NOT including member or employer pension contributions.
Where annual threshold income is below £110,000, there is no requirement to calculate adjusted income and the normal annual allowance of £40,000 will apply, even if annual adjusted income is more than £150,000.
What are the implications of this?
Any contributions in excess of your applicable annual allowance must be reported on your annual tax return and the excess will be subject to an immediate annual allowance charge at up to your highest marginal rate of income tax (20%-45%).
As you can see, the calculations to establish threshold and adjusted incomes are highly complex and many individuals, especially those who are self-employed and/or receive a considerable amount of dividend income, will not be certain of their income until the tax year in question has actually ended.
• In such cases, it may be prudent to restrict contributions to £10,000 gross within the tax year itself and then use the ‘carry forward’ rules to use any unused relief from 2016/17 in the 2017/18 tax year and so on.
• Transferring ownership of assets such as shares and rental property to a lower earning spouse could help to reduce levels of adjusted income.
• It may be possible for self-employed clients to make higher pension contributions to keep threshold income below £110,000, but it will no longer be possible for an employee of a firm to do this via a salary sacrifice arrangement.
• If you earn £110,000 or more, you may need to consult with your employer and arrange for pension contributions to be reduced to a minimum of £10,000 gross, perhaps with a corresponding increase in salary or other non-pension related benefits. You may also need to opt out of any auto enrolment arrangements.
• The changes could cause particular problems for those who are active members of final salary schemes, with some potentially difficult decisions to be made with regard to whether or not to remain within the scheme and face hefty tax charges, or whether to opt out and potentially miss out on some of their key employee benefits, such as pension contributions and (in some cases) death in service cover.
2. Pension Lifetime Allowance to reduce from £1.25 million to £1 million
The second key change is that with effect from 6th April 2016, the pension lifetime allowance (the overall value of pension benefits that you are allowed to make use of before facing a lifetime allowance charge of up to 55%) will reduce from £1.25 million to £1 million.
While £1 million may at first still sound like a substantial sum, a quick glance at the latest annuity rate tables shows that a pension pot of £1 million would provide a level income of just £57,840 per year for a healthy 65 year old male. Likewise, a final salary pension of £50,000 gross per year would also be valued at £1 million for lifetime allowance purposes, so it is clear that this latest reduction will affect a much wider cross section of the public than just the super wealthy.
If no action is taken (and no existing protection applies), the forthcoming £250,000 reduction in the lifetime allowance could cost up to £137,500 in lifetime allowance charges at the point of taking benefits (assuming that benefits are taken as a lump sum and any surplus over the lifetime allowance is taxed at 55%).
It’s not all doom and gloom
As a perhaps unintended consequence of the Government’s decision to taper down annual allowances from April 2016, transitional legislation has had to be introduced to allow the alignment of the dreaded ‘pension input periods’ much to the delight of Accountants and Financial Planners (as with many company accounting periods, some pension schemes have contribution years or pension input periods that do not correspond to the standard tax year).
From 2016/17 onwards, all pension schemes will follow the tax year and, to avoid detriment to those with unusual input periods, the 2015/16 tax year has been sub-divided into two ‘mini tax years’, with a maximum overall annual allowance of £80,000, assuming that you had already contributed at least £40,000 before the Budget on 8th July 2015.
This means that, for those that had already made 2015/16 pension contributions prior to the Budget, up to a further £40,000 ‘extra’ annual allowance will now be available, all of which will attract tax relief up to the highest marginal rate. For those who did not contribute before the Budget, the annual allowance for 2015/16 will be effectively the same as before the Budget announcement i.e. £40,000.
Likewise, there will be protection available for those that may be affected by the reduction in the lifetime allowance. Fixed Protection 2016 will allow you to preserve the current lifetime allowance of £1.25 million, although as a condition of this, you must cease all pension contributions and relevant accrual in final salary schemes by the end of the 2015/16 tax year.
For those that will have pension benefits valued in excess of £1 million on 5th April 2016, but wish to continue making pension contributions thereafter, Individual Protection 2016 will provide you with a lifetime allowance equal to the value of benefits on 5th April 2016, with just the additional benefits liable to a lifetime allowance charge when they are crystallised.