High earners can rest a little easier now that the Coalition has confirmed its stance on pensions tax relief. It was not as bad as first feared and it appears that not as many people will be affected as expected.
The cost of giving people tax relief on their pensions has doubled in recent years and it now costs nearly £19 billion a year (Source: HM Treasury, October 2010). Given the huge budget deficit Britain finds itself in, savings need to be made.
Labour had wanted to make significant savings of about £3.5 billion by withdrawing tax relief for those earning more than £130,000 but the Coalition balked at that idea when it came to power. Analysis at the time of the Emergency Budget in the summer suggested that reducing the amount that people could save in a pension from a maximum of £255,000 a year to between £30,000 and £45,000 would produce savings of £3.5 billion too.
But the Coalition’s number-crunchers have gone better than that. They believe they will save as much as £4 billion a year (Source: HM Treasury, August 2010) by limiting contributions to £50,000 a year from next April, which is far higher than the £30,000 limit many had feared (although it is still five times lower than the current limit of £255,000).
The Coalition estimates that its new plans will have an impact on about 100,000 people, not the half a million that could have been impacted with a £30,000 limit. The Coalition has also put paid to the rumours that the 40% tax relief for higher rate taxpayers would be cut. This is not the case and higher-rate taxpayers will continue to be allowed to keep tax relief at their highest marginal rate on pension contributions up to the £50,000 limit.
However, it was not all positive news.
The total amount you can save in a pension without incurring a hefty tax charge has been reduced from the current cap of £1.8 million to £1.5 million from April 2012. What’s more, away from the main headlines of the announcement, the Coalition revealed that the complicated formula for calculating the increase in someone’s pension if they are in a defined benefit scheme (better known as a final salary scheme) will change for the worse and this could land some employees with an unwanted tax bill.
From April the increase in accrued pension will be multiplied by a factor of 16, not 10 as at present, and this could hit workers who get a decent pay rise after more than two decades of service. For example, someone who has been a member of a final salary scheme for 25 years, earning £50,000 a year, who is promoted with a pay rise to £62,500, will be affected.
Their accrued pension at the start of the year would be 25/60ths of £50,000 or £20,833. This is revalued by the consumer price index, at a rate of 3%, to £21,458. But this accrued pension at the end of the year is 26/60ths of £62,500 or £27,083. The worker has therefore increased the value of their pension pot by £5,625 times 16 or £90,000. This is more than the annual allowance of £50,000, so they will suffer tax at 40% on £40,000.
However, the proposals allow for three years’ unused allowance to be carried forward and offset against excess contributions, which should help those who find themselves in such a situation. In effect, someone who has not used their allowance could plough in £200,000 over any four-year period. This will also help entrepreneurs, the self-employed and company owners who often have sizeable peaks and troughs in their earnings.
The Coalition’s plans will mean that people will need to think carefully about the tax implications of the changes. With the limits about to change, those who can afford to might want to make the most of the higher limits before they are introduced. This new regime simply creates clarity and will not affect most people. Crucially, many pension experts reckon that the changes should still allow people to build up a sizeable fund for their retirement.
If you have any questions about the forthcoming changes to pensions legislation, please contact me, Jamie Lewington, Principal Partner of St James’s Place Wealth Management on 01793 741246 or e-mail me.