From an advice perspective, maximising pension savings in the run-up to April, along with any unused annual allowance from previous years, will be high on the adviser action list for appropriate clients. At the same time, advisers and clients will need to be mindful of the impact of the lifetime allowance on pension savings.
Making use of tax allowances has always been important and as the end of the tax year approaches, advisers will need to make their clients conscious of the annual and the lifetime allowances as well as recent changes. This year, things have become slightly more complicated with the introduction of annual allowance taper rules, which will reduce the annual allowance for pension contributions substantially from £40,000 to £10,000 for some earners.
However, there are some ideas that can cut the tax impact on your clients’ pension pots and proper planning could save them a substantial amount.
Tapered annual allowance
Until now, a client would receive tax relief on annual contributions of up to £40,000. However, for people on high incomes, the government has introduced a sliding scale that reduces the £40,000 annual allowance to a minimum of £10,000. This takes effect in the tax year 2016/17.
The rules are complicated and require two different calculations of income to determine whether a client is affected. First, clients need to determine if their threshold income is more than £110,000. If it is, we need to calculate whether their adjusted income is more than £150,000 a year. If they cross both those thresholds, their annual allowance will be reduced by £1 for every £2 that the adjusted income exceeds £150,000.
Threshold income includes income from all sources, not just salary. So this includes income produced by investments and buy-to-let properties. We must also add back any income given up in a salary sacrifice arrangement that was set up after 8 July 2015. From this, deduct the pension contributions made to personal and occupational pensions. If the figure produced is less than £110,000, there is nothing to worry about – the client's annual allowance will be £40,000. If it is above, however, we need to calculate adjusted income. Adjusted income is calculated in a similar fashion to threshold income, but includes the pension contributions that a client and their employer make both from gross pay and via salary sacrifice.
Given the complexity of the income calculations, it is likely there are a number of people who are unaware that the new rules affect them. Worse still, some might not know if their income will exceed the £150,000 threshold. The government thinks there are about 300,000 people who save into pension pots that could be in this scenario.
Taper is likely to be most challenging when it comes to defined benefit schemes, because for most people in those schemes it will be difficult to work out the amount of annual allowance used up by their defined benefit pension scheme accrual.
Crucial carry forward
For those clients who exceed the annual allowance in a tax year, help could be at hand from carry forward. This enables them to use leftover annual allowance from the previous three tax years, increasing their annual allowance in the current tax year.
However, it is important to note that if a person has accessed their pension pot using pension freedoms introduced in April 2015 then their annual allowance for pension contributions, other than those made to defined benefit schemes, is automatically cut to £10,000 and carry forward cannot be used. The government is consulting on reducing the £10,000 limit to £4,000 from April next year.
Reliable relievable
Some clients may be caught by what is colloquially called the personal allowance trap. For instance, if they have an adjusted income between £100,000 and £122,000, they will lose their current tax-free personal allowance of £11,000 at the rate of £1 for every £2 their income exceeds £100,000 – with an effective marginal rate of income tax of 60 per cent.
However, if they pay relievable pension contributions personally they can take their adjusted income below the £100,000 threshold, and therefore regain their personal allowance.
A similar tactic can be used for parents who fear being subject to the high-income child benefit charge. They could effectively lose some or all of their child benefit if they or their partner have an adjusted net income in excess of £50,000 a year.
Paying tax relievable pension contributions can take the individual’s adjusted income below £50,000 in a tax year so they can preserve their full child benefit.
While there is no limit on the value of pension savings that can be built up over a client’s life, if they exceed the lifetime allowance then they will be subject to the lifetime allowance excess charge on the excess above their threshold. The charge is substantial. It can be applied in one of two ways, or combination of the both – either 55 per cent if taken as a lump sum or 25 per cent if taken as pension income. The pension income will also be subject to income tax which, if the recipient is a 40 per cent tax ratepayer, will result in an effective 55 per cent tax rate.
If the value of a person’s pensions exceeds the current lifetime allowance of £1m, they need to ensure they have explored any options available that can mitigate a tax charge. For example, could they register for Individual Protection 2014, Individual Protection 2016 or Fixed Protection 2016?
The cut-off date of 5 April 2017 is important for people with large-value pension savings, because applications for Individual Protection 2014 will not be accepted after that date. If the value of their pension scheme savings on 5 April 2014 exceeded £1.25m they should consider registering for Individual Protection 2014. Applications can be made to HM Revenue & Customs (HMRC) online. The individual will need an HMRC online services account to do so, but one can be set up as part of the application. Importantly, they will need to have details of what their pensions were worth on 5 April 2014 and a breakdown of the amount. If the individual does not know this detail they will need to obtain it from their pension scheme.
Individual Protection 2014 will protect the lifetime allowance equal to the value of the client’s pension savings on 5 April 2014, up to £1.5m.
In April 2016 two new forms of protection were introduced – Fixed Protection 2016 and Individual Protection 2016. Fixed Protection 2016 fixes the lifetime allowance at £1.25m, and Individual Protection 2016 fixes it at an amount equal to the value of the client’s pension savings on 5 April 2016, up to £1.25m.
The need for advice has never been clearer.
Phil Carroll, chartered financial planner and director, Intrinsic
Key points
As the end of the tax year approaches, advisers will need to make their clients conscious of the annual and the lifetime allowances as well as recent changes
It is likely there are a number of people who do not know whether the new rules will affect them
5 April 2017 marks an important cut-off date for people with large-value pension savings
