Taking ownership of funding a pension remains a very tax efficient way of saving for one’s retirement.
Although changes to the basic state pension in April 2016 will see the introduction of flat rate scheme said to be worth £144 per week, this is still insufficient for many of us.
As we approach April 5, the current pensions legislation provides a number of tax benefits to assist in boosting the value of a fund. However, we have to be aware of changes to pensions legislation, those being a reduction in the lifetime allowance (LTA) and annual allowance (AA) that could potentially expose one’s fund to a potential tax charge of 55 per cent.
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Pensions and the higher rate tax payer are seen by the Chancellor as targets for raising tax. Both allowances are reducing and therefore more individuals potentially will be liable for this tax unless they act.
The current LTA is £1.5 million, this being the maximum pension fund allowable at retirement, any excess attracting tax at 55 per cent.
As from April 2014 the LTA is reducing to £1.25 million, potentially exposing more pension funds to the tax charge. Individuals whose funds are close to the LTA should consider opting for fixed protection 2014 that secures a LTA of £1.5 million. However, contributions will have to cease from April 6, 2014.
The annual allowance (AA) is the maximum contribution that can be paid into a pension each year. The current AA is £50,000 per annum reducing to £40,000 in April 2014. Any contribution in excess of that will be taxed at the individual’s marginal rate.
Individuals wanting to contribute in excess of £40,000 should consider utilising ‘carry forward’ of unused relief from the previous three tax years. The unused relief is calculated by assuming an AA of £50,000 for each of the previous three years minus the contributions paid in each year.
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The individual has to pay the maximum in 2013/2014 before being able to utilise unused relief from previous years. The unused relief from 2010/2011 will drop out of the calculation if not used by April 5, 2014.
Consideration should also be given to pension input periods (PIP) that determine the tax year in which a contribution was paid but more importantly against which annual allowance.
Care should be taken if a contributions of £50,000 are being made and the PIP ends after April 5 2014. If there is no carry forward relief then this contribution is deemed to be paid in the tax year 2014/2015 as it is in the tax year that the PIP ends.
It would be tested against an AA of £40,000 and therefore would realise a marginal rate tax charge on £10,000.
Those earning in excess of £50,000 may wish to give thought to pension contributions and the positive effect on potentially recovering some or all of one’s entitlement to child benefit.
Individuals earning between £50,000 and £60,000 per annum have the entitlement to child benefit withdrawn at a rate of one per cent for each £100 of income in excess of £50,000. Making a pension contribution has the effect of reducing an individual’s adjusted net income. Taking a scenario of someone earning £52,000, they would lose 20 per cent of their child benefit.
If the individual makes a pension contribution of £2,000 gross, £1,600 net of basic rate tax, £1,200 net of higher rate tax. This would have the effect of reducing the adjusted net down to £50,000 and re-instating the full entitlement to child benefit.
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A similar scenario applies to individuals who earn in excess of £100,000. For every £2 of income in excess of £100,000 the personal allowance reduces by £1 therefore disappearing in full once earnings reach £118,880 for tax year 2013/2014.
Therefore the effective rate of income tax on this band of earnings is 60 per cent. Payments to a pension or gift to a charity have the same effect of reducing the adjusted net income. In this scenario a pension contribution of £18,880 would receive an effective rate of tax relief of 60 per cent.
Consideration needs to be given to the generous tax advantages available for funding contributions. However, at the same time higher rate taxpayers should be aware of pensions legislation changes that are exposing more and more pension funds to a potential 55 per cent tax charge.
* Trevor Law is a director with Merito Financial Services, chartered financial planners, based in Solihull.
E-mail: tilaw@meritofs.com