TPAS - The Pensions Advisory Service

Pensions Simplification

The following is a summary of the new tax regime rules, which came into force with effect from 6 April 2006.  Further details can be found on the FSA's website.

Lifetime Allowance

This is a statutory lifetime allowance for the maximum amount payable from approved pension schemes which will be treated as tax-privileged. This amount will be £1.5 million in 2006/07, rising to £1.8 million by 2010.

Funds in excess of the allowance will be subject, on vesting, to a recovery charge of 25%. If the excess funds are taken in pension form, the pension will be taxed as income. However, the individual can choose to take all or part as a lump sum which will be taxed at 40%. This will make the overall tax charge to be 55%.

There are two methods available by way of protection against the recovery charge for those with existing pension funds on A-day.

Primary protection - the value of A-day benefits will be expressed as a percentage of the £1.5 million and that percentage will continue to be exempt from the recovery charge. Thus a person with a fund of £2.25 million on A-day will always be able to have 150% of the limit, whatever level it is, and only incur a charge on the excess.

Enhanced protection - before A-day, anyone can cease active membership of their scheme and their ultimate fund, however much it is, will not be subject to a recovery charge.  This can apply to either those whose funds are over or below £1.5 million at A-day. This option can be revoked at any time before age 75.

Members of money purchase plans, including personal pensions, choosing Enhanced Protection, must stop payments in before 6 April 2006, or the option will be lost.

Members of salary-related schemes can continue to accrue benefits, but any increase will be tested when benefits 'vest' (e.g. transfer or retirement) and protection could be lost.

For the purposes of valuing benefits to measure against the allowance, all money purchase benefits will be taken at their asset value, while pensions building up in defined benefit schemes will be valued at £20 for each £1 of pension, irrespective of the individual's age. For pensions in payment, the A-day value will be 25 to 1.

Post retirement increases can be taken at any level (not limited to RPI as present) but a higher valuation factor will apply if a fixed rate of increase higher than 5% p.a. applies.

Annual Allowance

The annual allowance replaces the previous maximum annual contribution limits to approved pension plans. For defined benefit schemes it is the maximum allowable increase in accrual in a year. For defined contribution schemes it is the maximum amount of contribution in a year.

Individuals will receive tax relief on contributions up to £3,600 or 100% of earnings if greater, subject to the above Annual Allowance. Earnings are defined as earnings chargeable to UK tax. Unearned taxable income such as, investment income or capital gains do not qualify as relevant earnings.

There is no Annual Allowance in the year of vesting, i.e. contributions to a defined contribution scheme or increases in the value of a pension in a defined benefit scheme that take place in the year benefits are vested will be ignored for the purposes of the annual allowance.

Tax Free Lump Sum

After A-day the amount of tax free lump sum will be limited to 25% of the fund value which would be subject to the £1.5 million limit. Thus the maximum cash sum limit would be £375,000 and the limit will rise with inflation.

There will be transitional protection for those who would have had the right to a higher figure based on pre A-day rules.

Maximum lump sums from 'Section 32' policies vesting on or after A-day will be 25% of the fund.

Contributions

There is no limit on the amount of contributions that can be paid. There is a limit on the amount which enjoys tax relief. The annual limit is the lower of once times salary or £235,000. There is no limit at all in the year in which benefits are taken in full.

National Insurance rebates (on contracting-out) do not count towards the annual limit.

For those in Defined Contribution schemes, the amount counting towards the annual limit is the actual payments made. For those in Defined Benefit schemes, the annual contribution is obtained by calculating the annual increase in the members accrued pension over the previous year and multiplying by 10.

The current methods of obtaining tax relief on contributions will continue:-

a) Net Pay - those in employer sponsored registered schemes will get relief through the PAYE system.

b) Relief at Source (RAS) - under this method an individual pays net of basic rate of tax and the administrator reclaims the basic rate from the Inland Revenue. Higher rate relief is obtained by the individual through their self-assessment.

Those not earning or earning less than £3,600 per year, will be able to contribute up to £3,600 p.a.

Contributions can be made by an individual, their employer or former employer or any other individual. Tax relief accrues to the scheme member.

Employer-sponsored schemes (with active membership restricted to current employees) may choose to operate either net pay or RAS.

Refunds of contributions, on leaving an occupational scheme within 2 years of joining, will be taxed at 20% on the first £10,800 and 40% on the excess.

Investment

There will continue to be a limited range of investments that can be sheltered from tax within pension schemes.  Any investment in residential property, for example, will be taxed at 55% of the value of the property.

The government intends to allow people to invest in property through their pensions in Real Estate Investment Trusts (Reits).

Holding shares in the sponsoring employer and associated/connected companies will be limited to 5% of the fund value.

Scheme borrowing will be limited to 50% of the value of the fund as will loans to the employer. Loans to members will not be allowed.

Early Retirement

From April 2010, the earliest age at which retirement will be allowed is 55. Schemes can decide to bring this provision in from an earlier date.

Ill-health retirement will be possible from any age, scheme rules permitting.

Full commutation for serious ill-health will only be possible if life expectancy is less than 1 year and the commuted amount below the £1.5 million limit will be tax free.

Annuities

All benefits must vest and be applied to buy an annuity before age 75.

Pension income after 75 can be delivered via Alternative Secured Pension (ASP). ASP is an arrangement under which the member's fund can remain invested and the member draws down income each year between the minimum, 65%, and the maximum of 90% of the annual amount of the flat-rate single-life annuity at age 75. The maximum amount is determined annually.

Death Benefits - after age 75

On death after age 75, any residual fund can be used to purchase annuity for dependants. If there are no dependents the money reverts to the scheme or to the employer.

Death Benefits - before age 75

a) Before vesting i.e. benefits from which a retirement income is not yet being drawn.

All benefits can be taken as a:

• lump sum, or
• dependants pensions, or
• a combination of dependants pensions and lump sum.

Any amount taken as a lump sum is tax free provided it is below the lifetime allowance (£1.65 million).  Amounts in excess are taxed at 55%.

b) After Vesting

Secured income - i.e. income provided by an annuity. The benefits payable will be:

• the balance of any guaranteed period (maximum guaranteed period is 10 years). Any amount paid as a lump sum is taxed at 35%
• dependants pensions
• the balance of the capital paid from the annuity less income payments made before death. Only paid if death occurs before age 75 and subject to a tax free charge of 35%.

Unsecured income - i.e. income from a drawdown fund. The benefits payable will be:

• dependants' pensions, or
• any undrawn funds can be repaid but will be taxed at 35%.

Dependants' pensions may be paid to spouses and children under the age of 23, and to anyone else who, in the opinion of the trustees or administrators, was dependent on the member, up to the time of death.

Small Pension Funds ('Triviality')

At present the amount of pension that can be commuted entirely for cash depends on the type of pension plan that you are a member of.

If you a member of an occupational pension scheme, the Revenue will allow pensions that are less than £260 per annum to be commuted in full in exchange for a cash sum.

The rules are slightly more complex for personal pension plan holders. Here funds that do not include any protected rights can be taken as cash if they value less than £2,500 and it is the only personal pension plan held by a member. Plans that include protected rights presently cannot be accessed until age 60 years. Then funds can be taken as cash if the benefit that can be purchased is less than £260 per annum. Again, it must be the only personal pension plan held by the individual.

From 6 April 2006, the rules regarding triviality are changing so that where an individual has pension benefits that do not exceed 1% of the Lifetime Allowance it will be possible that these pensions can be commuted in full for cash.  Using a Lifetime Allowance of £1.65 million (2008/09) this will allow up to £16,500 to be received on grounds of triviality. However, you will only be able to commute benefits on the grounds of triviality between the ages of 60 and 75.

For members of defined contribution schemes, the total value of their pension funds will be tested against the trivial limit of 1% of the Lifetime Allowance.

For members of defined benefit schemes, pensions not in payment will be valued by a standard commutation factor of 20:1. Pensions in payment are valued by a standard commutation factor of 25:1.

The total of all pension rights held by an individual must be taken into account when establishing whether it would be possible to commute benefits on the grounds of triviality.

Overseas membership of a UK registered pension arrangement

The changes brought about by A-day now mean that an individual can contribute to a UK pension arrangement even though they or their employer is resident abroad. Nor is there any restriction on the amount of contributions that they or their employer my make. However, UK tax relief on contributions may not be available or it may be restricted in certain circumstances. Annual and lifetime allowances will apply to overseas resident members of a UK registered pension arrangement.

An individual may be eligible for UK tax relief on their contributions to a registered pension scheme if they are viewed as being a relevant UK individual during a tax year. The conditions are as follows:

• They have relevant UK earnings that are subject to UK income tax for that year,
• They are tax resident in the UK at some time during that year,
• They were tax resident in the UK both at some time during the five tax years immediately before that year and when they became a member of the pension scheme, or
• They, or their spouse, have for that year general earnings from overseas Crown employment subject to UK tax.

There is an annual limit for relieved contributions which has been set at the greater of:

• The individual's relevant UK earnings which are chargeable to UK income tax for the tax year, and
• The basic amount of £3,600 (or such greater amount as the Treasury may by order specify) if relief at source is provided.

Therefore, if you are classed as a relevant UK individual but have no relevant UK earnings then, UK tax relief is only available on contributions up to £3,600 in a tax year. Tax relief will be applied on a prorata basis depending on how many of the above conditions apply in each of the five tax years after ceasing to be a UK resident provided that their registered pension scheme operates relief at source. This will then be subject to a test against the Annual Allowance and a charge will apply if the annual allowance is exceeded.

Payments arising from a registered UK pension scheme to overseas residents are liable to UK income tax unless they are exempt by virtue of a double taxation agreement. Overseas residents are also subject to the Annual Allowance and Lifetime Allowance and therefore, are liable to charges should the occasion arise. However, these charges will normally only apply if the overseas resident were active members of a scheme whilst they were classed as being a relevant UK individual. Therefore, a member of a registered pension scheme will normally not suffer any charges if they have never been a UK resident and have never received UK tax relief on pension contributions to the scheme.

Miscellaneous

Where benefits are split (after A-day) as a result of divorce, the party who receives benefits will have these count against their lifetime allowance but the lifetime allowance of the party giving up the benefits will not be affected.

Small self-administered schemes will no longer have a requirement to appoint a pensioneer trustee.

In schemes where, prior to A-day, the rate of pension increases was limited to the RPI and, as a result, surpluses had built up, it may be possible for the excess to be released. This is more likely if the pension is paid as an annuity in the individual’s own name; but in the case of a final salary scheme, for example, no surplus may have built up because it was distributed as it arose. There may be a tax charge on any funds released, due to the size of the benefit or the age of the individual.

Q & As

I earn over the Lifetime Allowance, what should I do?

If the value of your pension benefits exceed the Lifetime Allowance, you can protect the value of your pre 6 April 2006 benefits from the Recovery Charge by one of two means, primary or enhanced protection.

Primary protection will value an individual's pension rights on 6 April 2006 and the value will then be used to produce a percentage uplift to the lifetime allowance. For example, if registered benefits on 6 April 2006 were £2.25 million this would equate to 150% of the lifetime allowance. Benefits would then be protected from the recovery charge until the value exceeded 150% of the Lifetime Allowance at the point they were drawn.

Enhanced protection will require an individual to cease being an active member and opt out of future registered pension provision before 6 April 2006 . No further contributions, or accrual of benefits is allowed, but benefits regardless of their value can be taken without the application of any recovery charge

For final salary schemes, benefits can still increase in line with pensionable earnings but there will be a ceiling on which earnings can be based - for those subject to the earnings cap, pensionable pay will be restricted to 1/14 th of the Lifetime Allowance. For others, if in excess of 1/14 th of the Lifetime Allowance, pay must be averaged over a minimum period of 3 years.

I do not earn over the Lifetime Allowance and am not likely to, do I need to Register?

There is no need to register if the value of your pension rights are unlikely to exceed the Lifetime Allowance

Some individuals, although they have pension rights which are under the Lifetime Allowance, will be entitled to a higher cash tax free cash sum than that allowed under the new regime. In this scenario there is no need to protect the cash sum built up to 6 April 2006 . This will be protected and indexed forward in line with the Retail Prices Index. However, any cash sum built up after 6 April 2006 will be limited to 25% of the post 6 April 2006 benefit value. Furthermore, if an individual subsequently transfers their pension rights to another arrangement, the protection extended to their pre 6 April 2006 cash sum will be lost.

Will I still be subject to the Earnings Cap if I opt for Primary Protection?

No. The Earnings Cap will be irrelevant if a member opts for Primary Protection.

Will I be subject to the Earnings Cap if I opt for Enhanced Protection?

If a member was previously subject to the Earnings Cap, increases in benefit will be restricted to 1/14 th of the Lifetime Allowance.

Is the onus on me or the scheme administrator to ensure that I do not exceed the limits?

It is expected that members will be required to fill in declarations, regardless of how large or small their pension is, confirming whether there is sufficient Lifetime Allowance available to cover the benefits that are to be paid.

If a member does not confirm any information about any other plans, schemes can assume that the member has exceeded their Lifetime Allowance. Consequently, a recovery charge would be applied to the whole of the benefit.

Who pays the Recovery Charge?

The onus will be on the member but in practice the Scheme will be expected to deduct this tax at source and pay it to HM Revenue & Customs.

Where the member resides abroad, responsibility will rest with the scheme administrator.

How is the Recovery Charge calculated?

A recovery charge will be applied to the excess over the lifetime allowance. The amount will depend on which option you elect to receive the benefit that is in excess. If pension is elected, it will be subject to a 25% tax plus the normal tax payable on receipt of their pension. If cash is elected, the excess will be subject to the recovery charge plus a tax charge of 40% on the balance (equating to a one off 55% recovery charge).

For example, assuming funds are in excess of the Lifetime Allowance by £1,000 and cash is elected on the excess:

• £1,000 x recovery charge of 25% = £250
• £1,000 less £250 = £750
• £750 x 40% = £300
• Cash payable = £750 - £300 = £450

The total effect of the recovery and tax charge equates to 55% on the excess.

Does my pension that I have in payment count towards my Lifetime Allowance?

Yes, the value of pensions already in payment will count towards an individual's Lifetime Allowance. If you have never taken pension benefits in the past, the whole of your Lifetime Allowance can be used when you elect to draw your pension benefits.

Where pension benefits have previously been taken, the remainder of your Lifetime Allowance can be used for further pension benefits. In the calculation to establish the balance of the Lifetime Allowance still available, the value of benefits previously taken will be adjusted as follows:

Benefits previously taken x Standard Lifetime Allowance at the time current benefits are taken.

Standard Lifetime Allowance at the time of the previous election of benefits.

Will the LA show on my P60?

HM Revenue & Customs has advised that administrators should notify pensioners annually of the value of their pension in payment and suggested that it could be included in their P60. The onus however will remain with the member to advise other pension parties of the value of their benefits in order that they can be tested against the Lifetime Allowance.

How do I register?

Rights should be registered with HM Revenue & Customs within 3 years of 6 April 2006 . However, if enhanced protection is sought, no further contributions or accrual of rights are allowed post 6 April 2006 . Therefore in reality, a decision will have to take place before 6 April 2006 . Members can however elect for primary protection at a later date.

Once funds have been registered with the Revenue, they will issue a certificate to the individual.

What are the time limits for registering?

Rights should be registered with the Revenue within 3 years of 6 April 2006 . However, if enhanced protection is sought, no further contributions or accrual of rights are allowed post 6 April 2006 . Therefore in reality, a decision will have to take place before 6 April 2006 . Members can however elect for primary protection at a later date.