An Update on Income Tax Relief For Pension Premiums

Changes to tax relief rules for contributions have been made or proposed at least 4 times in the last 2 years.  New rules, including a reduced Annual Allowance, started on 6th April 2011. Hopefully the latest rules will provide stability.

Tax Relief

Pension contributions made personally by members are limited to 100% of earnings for tax relief purposes, or £3,600 if higher. They obtain tax relief at the person’s highest marginal rate.

Member contributions to an employer’s scheme are usually paid gross and tax relief is given immediately through the PAYE system.

Member contributions to personal pension schemes are paid net of basic rate tax. The scheme claims the equivalent of basic rate tax from HMRC, even if the member is a non-taxpayer. If the member is a higher rate tax payer (40% or 50%), the extra tax relief is claimed via the self assessment tax return, if the tax coding has not already allowed for it.

The fact that contributions are paid net of basic rate tax can lead to confusion because it is the grossed-up figure that is used for tax relief and Annual Allowance purposes. For instance, although a person may write a cheque for £20,000 for a SIPP pension contribution, this is grossed up to £25,000 and so earnings need to exceed £25,000 for full tax relief and £25,000 counts for Annual Allowance purposes, below.

Pension Input Periods, below, are only used for the Annual Allowance tax charge and are not used for the purposes of tax relief. For tax relief, the important issue is the tax year in which the contribution is actually paid.

There is no provision for ‘carry back’ i.e. you cannot treat a contribution as being paid in a previous tax year for tax relief purposes.

The employer can obtain full corporation tax relief on its contributions, as long as they are justifiable as a business expense.

Annual Allowance

The Annual Allowance is the maximum amount of pension accrual that a person can enjoy for a tax year without a tax charge. The pension accrual includes all employee and employer pension contributions to money purchase schemes plus the increase in notional value of any defined benefits (final salary schemes).

From 6th April 2011 the main rules are:

1. The Annual Allowance will be fixed at £50,000 for each tax year.
2. Unused Annual Allowances from the previous 3 tax years can be carried forward (see below)
3. The Annual Allowance may remain fixed at £50,000 for 5 years.
4. A flat factor of 16 will be used for valuing defined benefit accrual.

Carry Forward

If you have not used all of your Annual Allowance in a tax year, the unused allowance can be carried forward to subsequent years, for up to 3 years. You have to be a member of a pension scheme in a tax year to carry forward an unused allowance from that year.

The current tax year’s Annual Allowance has to be used first, before unused allowances carried forward from previous years are used. Unused allowances are lost if they have not been used in the following 3 tax years.

For the 2011/2012 tax year, carry forward will be applied on the basis that the new rules had been in place for the 3 previous tax years.

Pension Input Period

Each pension arrangement has to set a Pension Input Period. Although many schemes chose a Pension Input Period which coincides with the tax year, other schemes have not.

The contributions paid in each Pension Input Period ending in a particular tax year are added together and this total is then compared with the Annual Allowance. It is only if all a person’s pension arrangements have adopted a Pension Input Period ending on 5th April that the Annual Allowance is compared directly with the contributions made in that tax year.

Exceeding the Annual Allowance

The total of all contributions for all Pension Input Periods ending in a tax year is calculated. If this total exceeds the current tax year’s allowance plus unused allowances carried forward from the 3 previous tax years, the excess is taxed as if it were added to the member’s earnings i.e. at 20%, 40 or 50%. The excess is declared on the person’s tax return and the tax is paid under the normal self assessment rules.

The excess contribution or pension accrual remain in the pension scheme. It is not distinguished from other funds in the scheme and is used to provide benefits in the normal way. Any pension is taxed as income and so, if the Annual Allowance is exceeded, the excess is taxed twice. As a result, it will be unlikely that anyone will have contributions to money purchase schemes in excess of the Annual Allowances.

Examples

Example 1: Simple Pension Input Periods

Simon has several personal pension schemes that all have Pension Input Periods ending on 5th April each year. He pays personal contributions totalling £20,000 and his employer pays contributions of £25,000.

Simon’s personal contribution is less than 100% of his earnings. Both Simon and his employer receive full tax relief on their contributions. The total contributions are less than the Annual Allowance and so no Annual Allowance tax charge is due.

Example 2: Pension Input Periods not aligned with tax year – no charge

Shirley has a SIPP and the Pension Input Period is 30th September. She contributes £40,000 in September 2011 and then £45,000 in February 2012. She does not have any unused allowances to carry forward. Her earnings exceed £85,000.

The only Pension Input Period ending in the 2011/2012 tax year is the Pension Input Period ending on 30th September 2011 and so the total of contributions for the Pension Input Periods ending in the 2011/2012 tax year is £40,000.

The only Pension Input Period ending in the 2012/2013 tax year is the Pension Input Period ending on 30th September 2012 and the only contribution in that Pension Input Period was £45,000 paid in February 2012. The total for the Pension Input Periods ending in the 2012/2013 tax year is £45,000. As a result no Annual Allowance charge is due in either tax year, even though the total actually paid in the tax year 2011/2012 was £85,000.

The full amount of £85,000 is allowed for tax relief in the tax year 2011/2012 because Shirley’s earnings exceed £85,000.

Example 3: Pension Input Periods not aligned with tax year – Annual Allowance charge due

Steven has a SIPP and the Pension Input Period is 30th September. He contributes £40,000 in December 2011 and then, not understanding the significance of Pension Input Periods, contributes £45,000 in June 2012. He does not have any unused allowances to carry forward.

Steven’s earnings in the tax years 2011/2012 and 2012/2013 exceed the contributions in those tax years and so he receives full tax relief on those contributions.

The Pension Input Period ending in the 2012/2013 tax year is the Pension Input Period that starts on 1st October 2011 and ends on 30th September 2012. The total contributions in that Pension Input Period were £85,000 paid in December 2011 and June 2012. The total input for the tax year 2012/2013 was £85,000 and exceeded the Annual Allowance of £50,000 by £35,000. As a result an Annual Allowance charge is due. This is calculated by adding the excess of £35,000 to Steven’s total income in his tax return.  If his total income in the 2012/2013 tax year had been £140,000, before the Annual Allowance charge, then part would be taxed at 40% and part at 50%.

Example 4: Carry forward

Stephanie has several personal pension schemes and a SSAS. All arrangements have always set their Pension Input Periods to end on 5th April. She wants to pay the maximum contribution for the 2011/2012 tax year.

Her total gross contributions (employer and employee) for the tax years ended 5th April 2009, 2010 and 2011 were £10,000, £50,000 and £20,000. Her unused allowances that can be carried forward are then £40,000, nil and £30,000, giving a total of £70,000.

Adding the carried forward allowances of £70,000 to the current year’s allowance of £50,000 means that Stephanie could have total contributions of £120,000.

Her earnings are £60,000 and so the maximum she could pay personally is £48,000 net (i.e. £60,000 when grossed up). Her employer could pay the balance.

If Stephanie and her employer decided to pay a total of £80,000, then she would use up her current year’s Annual Allowance of £50,000 and £30,000 that was carried forward from 2008/2009.

Alternatively, if Stephanie and her employer decided to pay a total of £50,000, then she would use up her current year’s Annual Allowance of £50,000 and no carry forward. She would lose the unused allowance of £40,000 that could have been carried forward from 2008/2009. In the next tax year 2012/2013, she would have nothing to carry forward from the years ending 5th April 2010 and 2012 with only £30,000 to carry forward from the year ending 5th April 2011 i.e. a potential total of £80,000.

Example 5: Carry forward not available
Shaun has never previously had any pension arrangements. He sets up a SIPP in the 2011/2012 tax year. The maximum input is then £50,000 because no allowances can be carried forward from a year in which he was not a member of any pension scheme.
Shaun’s brother Nigel is in the same situation except he had paid £1,000 into a personal pension scheme in the tax year 2004/2005. Although he did not pay any contributions in subsequent years, he was still a member of the scheme and so accrues Annual Allowances. His unused allowances are then £50,000, £50,000 and £50,000 meaning that the total allowable for the current tax year would be £200,000.
Forward planning
Any taxpayer with income for 2011/12 marginally in excess of £100,000 could find that pension contributions have an effective rate of tax relief of 60% due to the tapering of the personal allowance.
Clients should check their Pension Input Period for each of their arrangements, bearing in mind that one scheme can have more than 1 arrangement. If the period does not end on 5th April, great care should be taken with contributions as outlined above or you could consider extending the existing period. However, extending a period may itself generate an Annual Allowance charge because contributions paid over a longer period will count in one tax year.

In general, you should try to use up this tax year’s Annual Allowance plus any unused allowance from 3 years ago before you lose it.
If you do not have any pension arrangements at all but think that you will want to pay very high contributions in future, you should consider paying a token contribution to a scheme to start your Annual Allowances accruing for carry forward purposes.

FOR GENERAL INFORMATION ONLY

Please note that this Memorandum is not intended to give specific technical advice and it should not be construed as doing so.  It is designed to merely alert clients to some of the issues.  It is not intended to give exhaustive coverage of the topic.

Professional advice should always be sought before action is either taken or refrained from as a result of information contained herein.