Pension Planning for High Earners

The Finance Act 2010 was rushed through, before parliament was dissolved ahead of the general election. The new act includes clauses about extending the special allowance charge on pension contributions. Jeremy Pearson explains

The subject of higher rate tax relief on pension contributions has been the subject of much rumour in the past; before every Budget there is conjecture that the government will end it.
Something finally happened in this respect in March 2009, when it was announced in the Budget that higher rate tax relief for high earners would end in 2011. High earners were those with a taxable income of more than £180,000. If an individual had an income of between £150,000 and £180,000 for the current tax year or for either of the two preceding tax years, they will find their higher rate tax relief is ‘tapered' down according to their income.
What will happen is that they will lose 1% of tax relief for every £1,000 of income above £150,000. As they will be paying 50% tax on that slice of their income, this means that someone with an income of £165,000 would receive 35% tax relief on their pension contributions. Those with income of less than £150,000 will still qualify for higher rate tax relief at 40%.
But this proposal was changed further by the recent Pre-Budget Report, which included a proposal that the £150,000 limit is now the "gross income" limit, which is net income before deductions for pension contributions and charitable donations plus employer pension contributions. There is now also a floor of at least £130,000 "relevant income", which is as above but excluding the employer pension contributions.
These changes could feasibly mean that a 50% taxpayer will only receive 20% tax relief from 6th April 2011 on a pension contribution, of which one-quarter could be taken as a pension commencement lump sum with the retirement income taxed at 50%.
So by a very simplistic measure, they would receive 20% tax relief but have their benefits taxed at an effective rate of 37½%. Not an attractive prospect!
The natural inclination when a deadline is announced for a worsening of the tax position on an investment is to ‘fill your boots' before the deadline. We have seen this happen with the various A-Days that have occurred over the years. In fact, if you are as old as I am, you will be aware that they have been a regular occurrence since the ending of LAPR in 1984.
But the government has learnt a lesson over the years and at the same time as announcing the restriction of higher rate tax relief it also announced the "anti-forestalling" rules in Schedule 35 of the Finance Act 2009.
These are cunningly designed - although confusingly designed might be a better epithet - to prevent high earners increasing their pension contributions and getting 40% (this tax year) or 50% (next tax year) pension tax relief before it is reduced to 20%.
High earners (over £150,000 income) are allowed to still claim full tax relief on their "protected pension input amount", as at 22nd April 2009. This is their normal, regular pension savings as at that date; regular is defined as monthly or quarterly.
Now that the new relevant income limit has been introduced, from 9 December 2009 the tax relief restriction will also apply to those with income of £130,000 or over. No wonder no-one mentions "pensions simplification" nowadays - and if you want evidence of that look no further than the 124-page consultation document on "Implementing the restriction of pensions tax relief" that was issued with the Pre-Budget Report.
There has also been a concession made for individuals who pay contributions regularly but less frequently than quarterly - as repeated single premiums for instance - where an average of £30,000 can be paid with full tax relief being granted.
Otherwise, it is only when total contributions of more than £20,000 are paid that tax relief is restricted.
So the situation can be summarised as follows:

● Full tax relief is granted if the total annual income is less than £130,000 in any of the tax years from 2007/08 onwards.
● Full tax relief is granted if the total annual income was £150,000 or more if the individual continues as normal with their existing regular pension savings (including any employer contributions) and do not increase their pension savings on or after 22 April 2009.
● Full tax relief is granted if the total annual income was £130,000 or more if the individual continues as normal with their existing regular pension savings (including any employer contributions) and do not increase their pension savings on or after 9 December 2009.
● Tax relief will be restricted if the total annual income was £150,000 or more (or £130,000 or more from 9 December 2009) and the individual increases their pension savings and their overall annual pension savings are more than £20,000.

It may be helpful to list a number of examples where full tax relief can continue as before:

1. Alan has £111,000 income and makes a single premium pension contribution of £50,000.
2. Bert has £131,000 income and makes a single premium pension contribution of £15,000.
3. Clarice also has £151,000 income and has been making a monthly pension contribution of £3,000 since before 22 April 2009.
And an example where tax relief will be restricted:
4. Danielle has income of £200,000 and has been making a monthly pension contribution of £5,000 since before 22 April 2009, but she also pays an additional single premium of £30,000. (No single contributions were paid before 22 April 2009.)
In this example, only the monthly contribution would rank as a protected pension input amount and tax relief on the additional contribution will be restricted.
What happens in practice is that Danielle will receive full tax relief on the total contribution and then be subject to a special annual allowance tax charge.
This is the difference between the highest rate of tax she pays and the basic rate, so will be 20% for 2009/10 and 30% for 2010/11.
That means she will pay a special annual allowance tax charge of £6,000 in 2009/10.
As can be seen from the above, it makes a huge difference if your relevant income can be reduced to below the relevant limit.
Remembering, of course, this strategy only needs to be undertaken if the pensions contributions are increased or additional contributions made, with the total contribution being made exceeding £20,000 (or £30,000 repeated single) in any one tax year.
But for employees on PAYE, this may not be easily done as they are not usually in control of the payment or timing of bonuses, for example.
And before the Pre-Budget Report, there was a much touted strategy of using Gift Aid donations to reduce the relevant income.
This was in spite of the writing being on the wall in HMRC's Guidance for Individuals, published in April 2009, where they wrote "HMRC will look very closely at all arrangements designed to avoid the tax."
So it was no surprise to find that charitable donations are now not deductible when calculating relevant income and the definition now specifically excludes charitable donations under payroll giving, or gifts of qualifying investments to charities.
This is a clear sign of HMRC's determination to prevent people bending the rules and gaining full tax relief. And given that tax relief on pensions is estimated to equate to 2% of GDP, their resolve to do so is not surprising.

Jeremy Pearson is technical support manager at Canada Life