Draft Legislation – Reduction of the Pension Annual Allowance
With effect from the 2011/12 tax year the annual allowance is reduced from £255,000 to £50,000. It looks like this will remain unchanged until the end of the 2015/16 tax year at which point the Government have said they will consider options for indexing the annual allowance.
In practice this is a straightforward legislation change and therefore on first glance has minimal impact beyond its headline of restricting what can be paid into pension each tax year. The position does though become somewhat more complicated when you take into account Pension Input Periods and the proposed carry forward of unused allowance.
Pension Input Periods
Quite simply a Pension Input Period (PIP) is the period over which the amount of pension contributed to an arrangement is measured for the purposes of an annual allowance test. The period is normally 12 months but can be shortened on request.
It is the end date of the PIP that determines the tax year of assessment for annual allowance and for that reason an arrangement can only have one PIP per tax year. There is though nothing to stop an individual having different PIPs for different arrangements. For Example
Arrangement 1 starts 20/10/2010 and ends 20/10/2011 which is in the 2011/12 tax year.
Arrangement 2 starts 20/10/2010 and ends by election 20/11/2010 which is in the 2010/11 tax year.
A client who pays £20,000 into both arrangements on the start day would see one amount measured against the 2010/11 allowance of £255,000 and one against the 2011/12 allowance of £50,000.
It must be pointed out that the changes in annual allowance legislation only apply from 2011/12 onwards. A PIP that ends in the 2010/11 tax year is not caught by the new legislation. The annual allowance limit for all PIPs ending in 2010/11 remains £255,000.
The shortening of a pension input period under one or more arrangements so that they fall under the 2010/11 allowance rather than the 2011/12 one may therefore provide additional planning opportunities.
Carry forward of unused annual allowance
The nature of pension saving, in particular that of Defined Benefit schemes, means that it is quite common to see one off spikes in pension accrual. A well deserved promotion, a payment into pension following redundancy or an increased employer contribution after a particularly good year for example.
The Government was keen to provide a mechanism to protect against such one off spikes in payment from being caught by the new lower annual allowance and as a result is introducing carry forward of unused annual allowance.
From 2011/12 carry forward of unused annual allowance will be possible from up to three previous tax years. Of course for the first year of the new annual allowance the carry forward will relate to tax years where the annual allowance was higher than £50,000 so just for the purposes of carry forward calculations the annual allowance for each of the tax years 2008/09, 2009/10 & 2010/11 has been set to £50,000.
With regard to calculations for these three early tax years a couple of other concession have also been granted in relation to defined benefit and cash balance schemes. The conversion factor of pension accrual to fund value will be done using the original factor of 10 and not the new factor of 16. The opening value for the input period can be increased in line with the consumer price index.
Being pension simplification there is of course a condition that has to be met to qualify for carry forward and this is that you cannot carry forward unused relief from an earlier tax year unless at some point in that tax year the individual was a member of a registered pension scheme. There is though no requirement to have actually accrued any pension in the earlier tax year.
For the avoidance of doubt a member is defined in RPSM as “An individual who is either an active member, a pensioner member, a deferred member or a pension credit member of a pension scheme”. So the condition can be met just by being a paid up or pensioner member of any registered pension scheme.
How this will work in practice
Mrs B is director of company B and a member of the company pension scheme. Total monthly contributions between her and the employer are currently £2,000 per month and the company is looking to pay a one off £50,000 on her behalf. Her pattern of payments over the last thee tax years is :
• 2008/09 tax year = £ 24,000 regular plus £ 20,000 single
• 2009/10 tax year = £ 24,000 regular plus £ 30,000 single
• 2010/11 tax year = £ 24,000 regular plus £ 10,000 single
• 2011/12 tax year = £ 24,000 regular plus £ 50,000 single
In undertaking carry forward calculations the legislation firstly requires us to determine for each tax year the amount by which the annual allowance of £50,000 exceeds the pension input for the tax year.
Initial Carry Forward calculations
• 2008/09 = £ 6,000 (£50,000 allowance, £44,000 paid)
• 2009/10 = Nil (£50,000 allowance, £54,000 paid) Excess = £ 4,000
• 2010/11 = £ 16,000 (£50,000 allowance, £34,000 paid)
For the two earliest years any amount carried forward is then required by legislation to be reduced by any excess over annual allowance paid in subsequent tax years. Such deduction starting with the earliest year first and continuing until the whole excess has been deducted.
In other words if you had unused allowance for 2008/09 you would deduct from it any excess in 2009/10 & 2010/11. If you had unused allowance in 2009/10 you would only deduct an excess for 2010/11 and then only so much as had not already been deducted in the calculation for 2008/09 tax year.
JUST TO CONFIRM - A reduction is only required if a tax year has unused allowance and there is an excess in a subsequent tax year. This means any excess in 2008/09 is effectively ignored and the carry forward for that year is just zero.
Final Carry Forward calculations
• 2008/09 = £ 2,000 (£6,000 less £ 4,000 excess from 2009/10)
• 2009/10 = Nil
• 2010/11 = £ 16,000
• Total carried forward 2011/12 = £ 18,000
• Annual Allowance 2011/12 = £68,000 (£50,000 plus £18,000 carry forward)
Despite paying £74,000 in 2011/12 Mrs B only exceeds the annual allowance by £6,000 thanks to carry forward.
The question now is, at what rate is this £ 6,000 taxed?
Annual Allowance Tax charge
The old annual allowance excess tax charge was a flat rate of 40%. From 2011/12 onwards this will be replaced by an “appropriate rate” for the individual concerned. By “appropriate rate” it means at whatever level that individual pays income tax. To achieve this aim the annual allowance excess is simply added to the individuals reduced net income for the tax year to arrive at a total income figure subject to tax.
Summary
The mechanism for straddling pension income period is rather cumbersome but ultimately the addition of carry forward coupled with the higher than expected annual allowance of £ 50,000 works. One off spikes in pension are unlikely to be caught by the £50,000 limit and only those who have actively pursued full funding of their pension and continue to do so are likely to find themselves restricted. There will of course be some anomalies that get caught out but in the main the draft legislation achieves the stated objective.
This information is based on our understanding at the time of writing of the relevant law, rules, guidance or HMRC practice, which may change. It does not constitute legal or tax advice and must not be treated as such. Whilst every effort has been made to ensure the accuracy and completeness of this information, no representation or warranty, express or implied, is given in respect of it. We take no responsibility for any loss which may occur as a result of reliance on this information.
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