RegulationJun 23 2015

Make hay while the sun shines

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Make hay while the sun shines

Pension tax relief, the basics

Personal contributions made by relevant UK individuals will normally only be entitled to tax relief on contributions to a registered scheme if the individual has relevant UK earnings. An eligible individual may contribute up to 100 per cent of these earnings – or up to £3,600 gross pa (£2,880 net) regardless of their earnings – and will receive tax relief provided the pension scheme operates tax relief at source. Tax relief is not provided for individuals over the age of 75.

Where a non-employer third party makes contributions on behalf of an individual (such as a spouse or family member), tax relief is based on the individual on whose behalf the contribution was made.

Annual allowance

The annual allowance effectively limits the amount of tax-relieved contributions from all sources that can be made to all an individual’s pension arrangements in a year (normally the tax year, although this can depend on the pension input period).This is in effect a secondary test on all contributions and relevant benefit accrual after tax relief has been assessed on personal and/or employer contributions. The annual allowance for the tax year 2015/16 is £40,000.

Calculating tax relief

Tax relief via relief at source is available at a rate of 20 per cent for personal contributions to defined contribution pensions. For contributions above the higher and additional rate tax bands, a further 20 per cent and 25 per cent is reclaimable via self-assessment. All tax thresholds are increased by the gross amount of the personal contribution, hence both 40 per cent and 45 per cent tax relief may be available.

Higher rate tax relief

The pension contribution extends the basic rate tax band. Higher rate tax can be claimed up to the extent it is paid on all income, but always limited to total pensionable income. In all circumstances, relievable contributions are capped by the available annual allowance.

Tax relief within occupational schemes

Tax relief on personal contributions to an occupational pension scheme is normally given under net pay, where contributions are deducted from the employee’s salary before tax is calculated. Tax relief is obtained at source at the employee’s highest marginal tax rates, therefore they are not required to reclaim higher rate tax relief via self-assessment. Employer contributions are paid gross and are deductible as a business expense.

Employer contributions

An employer can contribute any amount to a registered pension scheme in respect of one of their employees or an ex-employee, regardless of that individual’s salary.

However, employer contributions to any registered pension scheme will only be able to gain tax relief without limit provided the contributions meet the normal rules of ‘wholly and exclusively for the purposes of business’, the regulations for allowable deductions laid out in the Income and Corporation Taxes Act 1988.

Assuming no carry forward, if an individual earns £30,000 in 2015/16 then their maximum relievable personal contribution is £30,000. The employer contribution will then be limited by the lower of the remaining annual allowance (£10,000) and the availability of corporation tax relief using the ‘wholly and exclusively’ rule.

Calculating accrual

For defined contribution arrangements, all contributions made by or on behalf of an individual (including employer contributions) are counted towards the annual allowance. Investment growth is not taken into account.

For active members of defined benefit schemes, all increases in the capital value of the pension and cash benefits are counted (with the exception of potential cash commutation) against the annual allowance. This valuation basis is on a ratio of 16 to one and is calculated using the formula in Box 1.

The pension value at the start of the year is then up-rated in line with CPI for the September preceding the tax year in which the valuation is taking place. To establish the annual pension contribution, subtract the uprated starting value from the value at the end of the year. An example of this is outlined in Box 2.

Annual allowance charge

Any pension contribution in excess of the annual allowance is added to the individual’s taxable income for the year and taxed at their marginal rate via self-assessment. Employer contributions will count towards the individual’s annual allowance and so large employer contributions may result in the employee being personally liable for an annual allowance charge at their own marginal rate of tax.

Carry forward

Carry forward is available as an option, within their terms.

• An individual may carry forward any unused annual allowance from the three previous tax years.

• An individual is able to carry forward only if they were a member of a registered pension scheme in the tax year that is being carried forward. For these purposes ‘member’ includes deferred, retired and pension credit members.

• Carry forward is based on a deemed annual allowance of £50,000 in 2012/13, 2013/14, and£40,000 for tax years from 2014/15 onwards, even if the individual’s relevant UK earnings would have been insufficient to gain full tax relief in the appropriate carried forward year.

• The annual allowance from the current year is used first and then the unused annual allowance from the three preceding years, using the oldest year first.

• Any contribution using carry forward does not need to be made to the same registered pension scheme of which that individual was a member in the previous year.

• Individuals do not need to report the use of carry forward from HMRC unless their contributions result in an annual allowance charge after carry forward is applied.

Critically, the amount of tax relief received on contributions will still be limited by earnings in the current tax year.

Money purchase annual allowance (MPAA)

The MPAA restricts contributions to DC pensions to £10,000 where the pension member has flexibly accessed a DC pension.

Individuals will still be entitled to a full £40,000 overall Annual Allowance which allows DB accrual to continue where DC pensions have been flexibly accessed.

Where the MPAA applies, the client will not incur an annual allowance charge provided the total contributions to DC pensions do not exceed £10,000, and the total of contributions to DC pensions plus DB accrual does not exceed £40,000.

Any unused MPAA cannot be carried forward. Where the MPAA applies, any unused annual allowance can only be carried forward where it is set against DB accrual.

The MPAA applies when the client has: opted for flexible drawdown before 6 April 2015; drawn income from a flexi-access drawdown account set up on/after 6 April 2015; drawn income in excess of their Gad limit from a capped drawdown account (this will automatically convert the drawdown into flexi-access); taken an uncrystallised funds pension lump sum; or received an income payment from a flexible annuity (one which can decrease).

The MPAA will not apply where a client takes a pension commencement lump sum (PCLS), or moves the remainder into flexi-access drawdown but has not taken any income from drawdown.

Danny Cox is chartered financial planner and head of financial planning at Hargreaves Lansdown