Here is a handy summary of useful information relating to pensions and tax.
1. Types of pension
a) The basic state pension is currently available to most UK individuals when they reach state pension age. The basic state pension depends on the number of years an individual has paid National Insurance or received National Insurance credits, eg while unemployed or claiming certain benefits. In order to receive the full basic state pension, an individual needs 30 years’ worth of National Insurance contributions or credits.
b) Personal pension schemes provide a retirement fund for individuals, whether they are employees or self-employed. They are offered by financial organisations such as banks or insurance companies.
c) Occupational pension schemes are provided by employers to their employees. Where a pension scheme is registered with HMRC, there are tax advantages for the individual and the employer, where the employer also contributes to the scheme. Starting from 1 October 2012, a new requirement was introduced for employers to provide eligible employees with automatic enrolment with a workplace pension plan. The relevant registration date will depend on the size of the employer, with larger employers having to register from 1 October 2012 while some smaller employers will have until 1 September 2016. The Pensions Regulator will write to all employers around 12 months before their staging date so that they will know when to automatically enrol eligible workers. A further reminder will be sent three months before the employer’s staging date.
2. Most common types of pension schemes
a) Money purchase schemes
With a money purchase scheme, the money invested by an individual is used to purchase units in the fund, and the value of those units is dependent on the underlying investments made by the fund manager. There is no guarantee of pension benefits.
b) Defined contribution schemes
With a defined contribution scheme, the benefits that an employee can take from the scheme are based on the employee’s salary and length of service.
On retirement, under both types of pension scheme an individual is entitled to draw a lump sum equal to 25% of the capital value of his entitlement (or 25% of the value of the fund in the case of a money purchase scheme) free of tax. The remainder will be taken as a taxable annual pension. If the value of the pension rights does not exceed £18,000, the whole amount may be paid out as a lump sum.
3. Maximum contribution and ‘relevant earnings’
a) Anybody (under the age of 75) can pay up to £3,600 per year into a pension scheme, regardless of the level of his/her earnings.
b) The maximum contribution for which tax relief can be obtained which can be made to a pension fund in any one tax year is 100% of an individual’s ‘relevant earnings’ for that year. ‘Relevant earnings’ include employment income (including benefits), trading income, furnished holiday lettings and patent income in relation to inventions.
c) From 6 April 2014 the annual allowance (see below) for tax relief on pension savings in a registered pension scheme was reduced to £40,000. This includes contributions made by anyone else into your pension such as your employer. If your pension savings exceed this amount you’ll have to pay a tax charge and give details of this on a your tax return.
4. Tax relief for pension contributions
a) Relief at source – applies to payments made into a pension scheme that are net of 20% basic rate tax. So, if an individual pays £800 into a pension scheme, HMRC will contribute £200 to bring the total contribution to £1,000.
b) If the individual is a higher rate taxpayer, extra tax relief is given by extending the basic rate band by the gross amount of the pension contribution. So, the new basic rate limit would be the current basic rate limit plus pension contribution times 100 divided by 80.
c) Net pay arrangements – applies to contributions to occupational pension schemes. Employees making contributions to an employer pension scheme will obtain tax relief via a net pay arrangement. Effectively, pay as you earn tax will be payable in respect of the gross pay less employee’s pension contribution. An employer’s contribution to an employee’s pension scheme is a tax-free benefit. However, if an employer pays pension contributions into the registered pension scheme of an employee’s family member, those contributions are a taxable benefit.
5. Annual allowance
a) The annual allowance represents the maximum amount of pension savings that can benefit from tax relief each year. It applies to both money purchase and defined contribution pension schemes, and it takes into account both the employee’s and employer’s pension contributions in the tax year.
b) The annual allowance for 2013/14 is £50,000. For 2014/15, the annual allowance is reducing to £40,000. Since 2011/12, any unused annual allowance can be carried forward and used to increase the annual allowance for that year by the unused annual allowance of the previous three tax years. Any unused annual allowance from previous years is utilised on a first in-first out basis.
c) Unused annual allowance can be carried forward from a tax year only if the individual was a member of a registered pension scheme in that year, even if no contributions were made in that year.
6. Annual allowance charge
a) Annual allowance charge is the tax charged on the annual increase in the capital value of a pension scheme over and above the annual allowance. The rate of tax depends on the level of an individual’s taxable income and whether the excess contribution falls below the basic rate or higher rate band.
b) If the amount of the tax charge exceeds £2,000, an election can be made by 31 July following the anniversary of the end of the tax year to have the charge paid from the pension scheme.
c) There are three other situations where part or all of an individual’s pension savings will not be liable to the annual allowance charge for the tax year. These are: if the member dies, retires due to severe ill-health, or is a deferred member whose benefits do not increase beyond certain levels.
7. Lifetime allowance
a) Lifetime allowance charge is the tax charged on the capital value of the fund that exceeds the lifetime allowance. The lifetime allowance for 2013/14 is £1.5m and will be reduced to £1.25m from 2014/15 onwards. The tax charge is triggered when payments are made from the retirement fund (payment of a pension or a lump sum).
b) Where the payment from the fund exceeds the lifetime allowance (at the time of crystallisation) then the excess is charged at either 25% (if the fund is used to buy a pension) or 55% where the fund is used to make a lump sum payment.
c) The tax liability is on both the individual and the scheme administrator. However, in practice, the scheme administrator will deduct the tax and pay it to HMRC.
8. Lifetime allowance protection
a) Pension savings before 6 April 2012: For people that had built up pension pots worth more than £1.5 million before 6 April 2006 when the lifetime allowance was introduced, lifetime allowance protection was introduced so that they didn’t have to pay the lifetime allowance tax charge on pension pots built up before this date. There are two main types of protection for pension pots built up before this date; these are primary protection and enhanced protection.
b) Pension savings before 6 April 2014: From 6 April 2014, the lifetime allowance was reduced to £1.25 million. A new form of protection called fixed protection 2014 was introduced to protect those who had built up, or think they may build up, pension pots of more than £1.25m but no more than £1.5 million. A further form of protection called individual protection 2014 will also apply from 6 April 2014. For those with pension savings above £1.25 million, it will provide protection of those savings with a value on 5 April 2014 of between £1.25 million and £1.5 million. There are deadlines by which applications for protection should be made.