The taxing job of pension planning

Julie Darlington, director of regulation, 2plan Wealth Management, looks at how the complexities of the tax system impact pension planning.

The financial services industry has taken the brunt of an unprecedented amount of significant changes in the past few years: global economic recession and a banking crisis; pensions reform; the RDR and various FSA thematic reviews; and most recently a new political era under the recently formed coalition government.

Interestingly, since 1997 we have had 13 different pensions ministers – hardly the ideal foundation for stability in one of the most important posts in government. At the time of writing however, the good news is the industry appears overwhelmingly to have taken to the appointment of Ian Duncan-Smith as work and pensions secretary but perhaps more importantly, also to Steve Webb as the new minister for pensions.

Already on the Twitter social networking site, Steve Webb has announced that he will head up “radical policy reforms that aim to fix years of damage to the pensions system”. The threat of plans to restrict further the amount of tax relief on pension contributions for higher earners seems to have taken a back seat, at least for the time being.  We would however welcome prompt clarification on tax relief levels and tax free cash entitlements and await the outcome of the proposals for the ending of compulsory annuitisation at age 75 promised.

With such uncertainty ahead it is worth taking stock of the current tax environment we have to work within for those who do fall into the higher income tax brackets for future pension planning.

We look at the interaction of the special annual allowance, personal annual allowance and additional higher rate tax as they stand under current and foreseeable legislation.

The background

Starting with the 2009 Finance Act there has been ever increasing measures taken by government which attack the income tax position of high earners. For the 2010/11 tax year we have three such measures coming into force at the same time all of which are unfortunately rather related:

1. Additional higher rate tax: new 50% tax band for those with income over £150,000
   
2. Personal allowance: reduction in personal allowance for those with adjusted net income over £100,000 at the rate of £1 for each £2 of income
   
3. Special annual allowance: tax charge on excess of either 20% or 30% depending upon personal circumstances.
   

In practice

For advisers it is important to look at some practical examples of how these three changes work and where they interact with each other. But unfortunately, the myriad of different combinations and possibilities makes it impossible for us to do any more than scratch the surface with the following examples.

• Reduced net income: This is essentially the amount an individual is assessed for tax for the year. It is used in the examples to determine the tax charge that applies on a special annual allowance excess. The tax charge is 20% on the amount of the excess that when added to reduced net income is below £150k, plus 30% charge on the amount of the excess that when added to the reduced net income exceeds the £150k higher rate limit.
• Adjusted net income: This is essentially all taxable income less full deduction (not restricted to £20,000) for relief at source pension contributions. If this is below £112,950 then personal allowance starts to reappear.
• Relevant income: This is the reduced net income from above plus any net pay contributions made minus the total tax relievable pension contributions paid subject to a £20,000 maximum. If this is below £130k then anti-forestalling does not apply.

The example cases

We have considered just two examples of how this works in practice (see boxes) to try and outline the complexity in assessing what might be the most effective means of making pension contributions and how the outcomes differ depending upon the options chosen.  These are only for guidance and represent only a small fraction of the different permutations of contribution options available.

These are just two examples – it is impossible to try and cover every possible combination of circumstances in an incredibly complex pension contribution and taxation system.

You can see that making a pension contribution today can have a significant impact upon the taxation outcomes depending upon how income has been structured for any given individual’s circumstances.

The problem is there are so many variations possible that it is difficult to consider every variable and this just serves to highlight the need for a combination of professional financial and specialist taxation advice to look more closely at each client’s individual circumstances to make an assessment as to which contribution basis might best fit.

In an ideal world, on our worked example, we would know exactly what reduced net income to use for the tax year. In reality, this figure will not be known until after the end of the tax year when all the required figures come together for the self-assessment return. Any variations in the reduced net income figure would mean all other figures change as well.

Professional advice is crucial

The only true conclusion that can be drawn is it is now more difficult than ever to accurately plan ahead and to decide which of the many and varied payment combinations is best suited for any individual client. The need for professional financial advice for this area of planning is perhaps more crucial than ever before.

Paying a personal £60,000 contribution (gross) to regain personal allowance

Adjusted Net Income = £100,000
Personal Allowance = £6,475
Reduced Net Income = £160,000

Basic Rate Tax = £7,480                     £37,400 @ 20%
Extended Basic Rate Tax = £12,000     £60,000 contribution @ 20%
Higher Rate Tax = £22,450                 £160,000 - £97,400 - £6,475 @ 40%
Additional Higher Rate Tax = £0         Payment of pension contribution extends higher rate tax band to £210,000

Relevant Income = £140,000
Special Annual Allowance = £8,000     £40,000 excess contribution added to £160k is below higher rate limit so all taxed at 20%

Total income tax due = £49,930

Total income tax saving is £7,590 made up of £1,000 as a result of avoiding the Additional Higher Rate, plus £4,000 marginal rate relief on £20,000 of the contribution, plus £2,590 from tax relief generated by the personal allowance. Also receives £12,000 tax relief on contribution.

Salary sacrifice used so that Employer pays £60,000 contribution instead

Adjusted Net Income = £100,000
Personal Allowance = £6,475
Reduced Net Income = £100,000

Basic rate Tax = £7,480             £37,400 @ 20%
Extended Basic Rate Tax = £0     No personal contribution
Higher Rate Tax = £22,450        100,000 - £37,400 - £6,475 @ 40%
Relevant Income = £160,000
Special Annual Allowance = £8,000    £40,000 excess contribution added to £100k is below higher rate limit so all taxed at 20%

Total income tax due = £37,930

Total income tax saving is £19,590 made up in the same way as above plus an additional £12,000 as a result of the £60,000 reduction in higher rate taxable income.