A pension is a long-term fund into which sums of money or other assets are put aside during a person’s working years so that periodic payments can be made in order to support them during their later non-working lives. In the UK, there are really two main types of scheme. The first is a ‘defined-benefit’ scheme where on retirement the pension income of an individual is normally tied to a percentage of their earnings when they retire and comes with a reasonable expectation of continuity. These schemes are traditionally offered by the very largest of employers who are able to underwrite pensioners’ incomes by topping up the collective fund out of assets, profits or cash flows. These defined-benefit schemes are becoming less popular with employers who take on the financial risk caused by people living longer and, in an economic downturn, poor returns on the schemes’ investments. Public sector schemes, including the state pension entitlement, remain as these are easier for the government to fund because it funds pensions through taxation.
The second form is a ‘defined-contribution’ scheme where whatever a member pays into the fund during their working life is used to fund their pension when they are no longer working. Their pension income is therefore dependent upon how much they put aside and how well the underlying investments perform within their fund.
The first pensions
People had been unable to fund retirement for many centuries, often working until they dropped. During the Industrial Revolution in the mid-19th century there were moves by liberal individuals to reform savings for old age and Industrial and Provident Societies were formed. However, the first state Pension Act came into force in 1909 followed quickly thereafter by a National Insurance Act. Pension laws have been reformed a number of times since in response to mismanagement of scheme assets and ensuring life insurance companies do not make promises to attract business they are later unable to be able to keep. The main attraction behind an authorised pension scheme is its tax efficiencies – a boost of 25 per cent is available to the investment made by a ‘defined contribution’ member and in most cases the fund value is not within the scope of capital gains tax or inheritance tax.
The size of the UK pension market is difficult to gauge, but it is estimated some £5 trillion of assets are under management for UK-based present and future pensioners.
Market growth is driven by additional contributions to pensions funds (around £2.0bn-2.5bn per month), and regulations that bring more individuals within the scope of automatic pension provision such as Auto-Enrolment for UK employers.
The underlying principle of UK pensions is the deferral of income tax on earnings from employment and/or self-employment that are set aside into a recognised pension arrangement. Rather than pay tax now on such earnings you, as a member, pay income tax when you draw on the pension fund. Even then, up to 25 per cent of the fund you build up will be tax free.
In the meantime, pension funds may grow free of tax and the fund is normally paid out tax free on death before age 75.
This tax favoured treatment of contributions, growth and withdrawals is subject to limits on the contributions paid and total value accrued.
To the extent that contributions and total funds are within the tax favoured allowances, any UK resident under age 75 may pay into a pension fund. There is no tax relief on contributions paid at or after age 75 and pension funds are subject to income tax on death thereafter.
The tax breaks are to encourage long-term saving for retirement and come hand-in-hand with restrictions on when and how the pension fund may be accessed. In particular, no withdrawals can be made before age 55.
This article mainly deals with the rules and choices that apply to ‘defined contribution’ – personal pension plans, certain types of employer pension schemes and additional voluntary contribution facilities associated with these. Defined benefit pension schemes (final salary and career average schemes) may be more restricted or taxed differently, especially on death. These latter schemes are becoming less favourable and the tax case for ‘defined contribution’ schemes is what this article explores.
Tax relief on contributions:
Qualifying personal pension contributions attract tax relief at an individual’s highest marginal rate (ie, up to 45 per cent). Those with total annual income of more than £100,000 will have a reduced personal allowance or none at all. Personal pension contributions serve to reduce income for this purpose and, to the extent that the personal allowance is increased as a result, effectively receive 60 per cent tax relief. Additional personal contributions may be particularly beneficial for those with total income of £125,000 or more.
Individuals can contribute up to 100 per cent of earnings in any tax year subject to a limit of, generally, £40,000. The limit is known as the ‘Annual Allowance’ and is subject to reduction for individuals with high income.
A pension contribution of up to £3,600 per annum gross can be paid for any UK resident, regardless of age (up to age 75) and earnings.
Annual personal pension contributions can be paid in excess of these limits but will not get tax relief and will not therefore be attractive.
Contributions can be paid by one person for the benefit of another. For example, by making annual gifts, grandparents can put aside modest sums in an authorised pension scheme for their young grandchildren.
5 April is the deadline to make any pension contribution for the current tax year.
There is no limit on employer pension contributions; however, employees will pay income tax on employer contributions which, in aggregate with qualifying personal contributions, exceed the Annual Allowance in a tax year. Tax efficient employer contributions are not restricted to 100 per cent of the employee’s earnings, as personal contributions are, although corporation tax relief may be denied where an employee’s total remuneration package is excessive for the employment duties performed. This is something that private companies need to watch closely.
For members of final salary pension schemes (and for Additional Voluntary Contributions purchasing ‘added years’) it is the increase in value of pension benefits over the previous year that is tested against the Annual Allowance. For this purpose, the capital value of any increase in annual pension benefits (because of extra service and salary increases) over and above inflation (CPI) is 16 times the annual increase.
Where the Annual Allowance is exceeded in a tax year, any Allowance unused in the previous three tax years is carried forward to cover all or part of the excess contribution. The general Annual Allowance has been £40,000 since 2014-15. Unused Annual Allowances can be carried forward but only for a limited number of years and an individual must have had some form of pension plan in those years.
From 2016-17, the general Annual Allowance is reduced by £1 for every £2 of income over £150,000. Income for this purpose is that from any source, not just earnings, and includes interest, dividends and rental income. It also includes the value of any employer pension contributions. For those with total income of £210,000 or more, the allowance is fully tapered down to the minimum £10,000.
For those people taking advantage of ‘flexi-access’ to their defined contribution pension funds – essentially taking anything more than their tax-free lump sum, the Annual Allowance is restricted to £4,000, with no carry forward.
For aggregate pension benefits up to the Lifetime Allowance, tax-free cash is normally 25 per cent of any pension fund, regardless of source, the maximum currently being £250,000 from a fund of £1m.
For those with any of the protections listed below, a higher lump sum is probably allowed, being 25 per cent of the appropriate Lifetime Allowance; however, the 25 per cent lump sum allowance does not necessarily apply under Primary or Enhanced Protection.
Occupational pension funds dating from before April 2006 may also enjoy ‘scheme specific protection’ of the tax-free cash where this was more than 25 per cent under pre-April 2006 rules. Such protection is automatic but is normally lost on transfer to a new arrangement.
Any part of an individual’s pension fund that is not within the tax-free cash allowance is used to provide an income. There are a number of options.
The balance pension fund is used to buy a guaranteed lifetime income from an insurance company.
Annuities can include an income payable to a dependant on death. From April 2015, such joint life annuities can be set up to include any named beneficiary (not just spouse, civil partner or financial dependant).
Annuities can also include a ‘guaranteed period’ where the annuity income continues to be paid even if the annuitant has died during an initial period.
Dependant/beneficiary/’guaranteed period’ annuity income is not taxed where:
– the original annuitant died before age 75; and
– no dependant/beneficiary/guaranteed annuity income was paid before 6 April 2015.
Otherwise, the dependant/beneficiary pays income tax on payments received.
Rather than buy an annuity, the balance pension fund continues to be run as an investment fund with money drawn as and when required. Any money drawn out is taxed as income.
From April 2015, any one over age 55 can draw on their pension funds as rapidly as they wish, taking the whole fund as a single income payment, for example. That would not be wise, however, and because most pension savers tend to be prudent people, this action is rarely encountered.
On death of the individual, the drawdown fund is available to a dependant or any nominated beneficiary who may:
– take the whole fund as a lump sum;
– continue with income drawdown in their own name; or
– buy a dependant’s or beneficiary’s annuity.
Tax on death
Lump sum death benefits held under trust and paid direct to beneficiaries are exempt from inheritance tax. However, not all pension policies are automatically constituted as a trust – so called Section 32 Buy Out plans and Retirement Annuity plans (pre 1988 personal pension plans) will be paid to the policyholder’s estate on death (and, so, be liable to inheritance tax) if steps have not been taken by the policyholder to place the policy in trust.
While generally inheritance tax should not apply, individual pension funds may be subject to income tax. There may also be additional tax to pay should the individual’s pension arrangements exceed their Lifetime Allowance on death before age 75.
On death, an individual’s remaining pension funds can be distributed as cash lump sums or passed on as in specie pension plans to the individual’s dependants or other persons nominated by the individual.
Death before age 75
For pension arrangements within the Lifetime Allowance, any lump sum or withdrawal made from an inherited dependant’s/nominee’s pension plan is tax free, as long as such action is taken within two years of death.
Death after age 75 (or if not addressed within two years of death)
Any lump sum or withdrawal made from an inherited dependant’s/nominee’s pension plan is taxed as income.
There are more detailed rules outside the scope of this article, so professional advice should be sought.
Authorised pension schemes are essential long-term savings plans for a person if they wish to avoid poverty in old age. Sensible, early provision is the best way to ensure that the compounding effects of long-term growth maximise the investments made. These investments are also boosted by substantial tax breaks which mean that traditional pension provision is the most sought after method for providing for old age. The numbers add up.
Traditional pension provision has suffered some knocks over the last few years, such as unauthorised use of funds by employers and the miss-selling of pension loan schemes. This in turn has led to tighter legislation to protect the future pensions for all of us.
Martin Reynard is financial planning manager at Blick Rothenberg