Government cuts will hit your pension

As the coalition unveils dramatic changes to pension tax breaks, we look at who will be affected.

Earlier this month, the Treasury announced a raft of changes to the pension regime. One of the most important new rules will restrict pension tax breaks for higher earners, saving the government around £4 billion a year.

How do pension tax breaks work?

Under the current rules, you’re entitled to tax relief on any pension contributions you make at your highest rate of tax. This means you’ll effectively get back the income tax you have already paid on your pension savings.

If you’re a basic rate taxpayer, you’ll qualify for tax relief at a rate of 20%. In other words, if you pay £80 into your pension fund, it’ll turn into a gross contribution of £100 once 20% tax relief has been added by HM Revenue & Customs. Meanwhile, higher rate taxpayers qualify for tax relief at a rate of 40%, and additional rate taxpayers will get 50%.

Right now, you’re able to save up to 100% of your earnings into a registered pension scheme with a maximum contribution limit of £255,000 a year.

The new government rules

Under the Labour government a complex set of rules, due to take force in April 2011, would see tax relief tapered away for those earning more than £130,000. But the coalition’s recent announcement has simplified matters a great deal.

Instead of reducing rates of tax relief for higher earners, the overall contribution limit will be dramatically reduced from £255,000 a year to just £50,000 from 6 April 2011. This is actually significantly more generous than the previously rumoured limit of £30,000 to £45,000.

This £50,000 allowance is the limit you can pay annually into your pension and still qualify for tax relief. This includes both individual and employer contributions. Anyone exceeding the limit potentially opens themselves up to extra tax penalties.

This may sound like a huge reduction, but the number of savers likely to put away more than £50,000 a year into their pension is relatively small. The government estimates the rules will affect around 100,000 individuals, and 80% of them will be earning more than £100,000. The changes will have no impact on low and medium earners who will continue to enjoy tax relief in the same way as they do now.

All savers will still get tax relief at their highest rate of tax, which means those who are paying the 50% additional tax rate, will be eligible for a 50% tax break on their pension payments. What’s more, any unused allowance from the three previous years can be carried forward, making it possible to make a greater contribution than £50,000 in one year without falling foul of the rules.

The lifetime allowance

In addition to the dramatic reduction in the annual allowance, the lifetime allowance will also be cut on 6 April 2012 from £1.8 million to £1.5 million. This represents a new limit on the total value of your pension benefits before tax charges apply.

If your pension value exceeds the lifetime allowance a ‘recovery charge’ will apply on the excess amount. Where the excess is taken in the form of a pension, the recovery charge is 25%. However, if it’s paid to you as a one-off lump sum, the penalty is a whopping 55%.

Given the severe tax penalties, the reduction in the lifetime allowance is crucially important if you have a large pension pot. The government plans a further consultation on how to protect savers who have already built up pensions worth more than £1.5 million overall. Tax charges won’t be applied retrospectively if you’re in this situation.

Note that neither the annual allowance nor the lifetime allowance will be index-linked until 2016 at the earliest. This means the limits will reduce in real terms as a result of inflation, which will likely mean more pension savers will be affected by the changes over time.

How will the new rules affect defined benefit schemes?

The new rules will also have an impact on defined benefit schemes such as final salary pensions - and they won’t just affect very high earners.

Here's why: under the current regime, if you’re awarded a pay rise it is be deemed as a contribution to your pension. To reflect the value of the benefits building up in your scheme, such contributions are currently multiplied by a valuation factor of 10. In other words, a payment made into your scheme is said to increase the benefits you get out of the scheme when you retire by a factor of 10.

But now the coalition has decided to increase the valuation factor to 16.

What does this mean in practice?

If your pay rise is said to have increased the value of benefits from your final salary scheme by say, £4,000 (this figure will depend on the amount pay has increased, the number of years service in the scheme and the accrual rate used), a valuation factor of 16 will lead to a notional contribution of £64,000, instead of £40,000.

So what?

As you can see, this exceeds the annual allowance by £14,000, triggering a tax charge. At a rate of 40%, that could land you with a tax bill of £5,600. If the valuation factor had remained at 10, the notional contribution would be £40,000 and fall comfortably within the allowance.

In this way, if you’re earning around £50,000 and you’re awarded a decent pay rise, you could lose out. That said, unused annual allowance can again be carried forward from the three previous years to limit or eradicate the charge. And pay rises can also be averaged out over three years to reduce the level of the notional contribution to the pension. So in reality, this change is only likely to affect high-earners with long service records in final salary schemes with generous accrual rates.

What’s more, the government plans to consult on allowing people to pay significant tax charges out of the pension scheme itself, rather than their own income.

The next steps

The annual allowance won’t drop until April 2011. If you’re a high earner, there’s an opportunity to pay a large top up into your pension now before the new rules take force. After April 2011, saving more than £50,000 into a pension annually won’t be tax-efficient. In this situation, you would be better off looking at other alternatives to save for retirement such as ISAs and National Savings & Investments.

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