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Pensions Simplification
On 10th December 2003 the Government published “Simplifying the taxation of pensions: the Government’s proposals”. Some of the original proposals have been modified and a lot more detail has been forthcoming. Further details were announced in the Budget 2004. Amendments and further regulations seem to be issued almost daily so the following will be subject to change and simply represents our current understanding of the situation.
A-Day
It was confirmed in the Budget that the proposals for the simplification of the taxation of pensions would be implemented from 6th April 2006 (A-Day)
Lifetime Allowance
All individuals will be entitled to a lifetime allowance of £1.5M in 2006. This figure will be increased to £1.6M in 2007, £1.65M in 2008, £1.75M in 2009 and £1.8M in 2010. It will be reviewed every 5 years. Funds will be tested against the lifetime allowance when a benefit comes into payment.
Defined benefit pensions will be valued using a standard 20:1 factor provided total dependants’ benefits do not exceed 100% of the member’s benefit (before commutation) and pension increases are limited to RPI or less. The factor is applied to the net pension after commutation and the cash value of any commutation is then added.
Where schemes offer benefits greater than those set out in the previous paragraph they can agree non-standard factors with the Inland Revenue.
Pensions already in payment at A-day, other than pensions receivable as a dependant, will count towards an individual’s lifetime allowance where that individual has a new benefit coming into payment after A-day. Such pensions will be valued using a factor of 25:1, the assumption being that tax free cash relating to that benefit will have been taken. The factor is applied to the annual amount of the pension at the time of valuation (we understand this to mean at the time the new benefit comes into payment). For income withdrawal cases the annual amount of pension is deemed to be the maximum available withdrawal at the time of the valuation.
Existing income withdrawal plans at A-day will become subject to the new rules for unsecured income (assuming the member is still under age 75) but the changeover can be delayed until the next triennial review.
Recovery Charge
When the value of a member’s benefits exceeds the lifetime allowance the excess will become liable to a recovery charge at a fixed rate of 25%.
Once the recovery charge has been applied the balance of any excess may be taken as taxed pension or as a taxed lump sum. Tax will be at PAYE rate. Thus the total recovery charge in these circumstances for a higher rate tax payer will be 55%.
Annual Allowance
Each individual will be able to benefit from an annual allowance in respect of the growth in their pension savings, of up to £215,000 in 2006-07, without any adverse tax consequences. This will be increased by £10,000 each year so in 2010 it will be £255,000. It will then be reviewed every 5 years.
Where growth in any tax year exceeds the annual allowance the individual will be taxed on the excess.
The annual allowance will not apply in the tax-year when benefits are taken in full.
The annual allowance takes account of all contributions to defined contribution schemes and all increases in the value of defined benefit schemes.
The following may be ignored for purposes of the annual limit:
- Contributions paid to a DC scheme and growth in value of DB benefits in any year in which benefits are wholly vested. This is primarily but not exclusively designed to assist those who retire as a result of ill-health or redundancy.
- Member contributions in excess of 100% of earnings as these will not be tax relievable.
- Age-related NIC rebates to COMPS and Appropriate PPSs
- Transfers between registered schemes and transfers from approved overseas schemes where contributions to those schemes have not received UK tax relief
- Decreases in value of DB benefits. Such decreases in one year cannot be offset against increases in another year, nor can decreases in one scheme be offset against increases in another scheme
- Falls in value of DC schemes as a result of investment performance
- A pension credit granted on divorce
AVCs, which buy added years will not count as a contribution but the increased value of the benefit purchased will count towards the annual allowance. Money purchase AVCs will count as a contribution.
In DB schemes the increase in the member’s pension entitlement from one year to another will be valued using a factor of 10:1. It will be the resultant deemed capital value, which will count towards the member’s annual allowance.
There will be a new section in the self-assessment tax return, which will enable members to calculate and report any liability arising from excessive increases in their annual pension savings.
Pension Age
The minimum age for taking pension benefits will increase from age 50 to age 55 by 2010; pension schemes will be able to decide how to make this change. Existing contractual rights for members of occupational schemes to take benefits after age 50 on redundancy will be protected.
All benefits will have to be vested by age 75.
Tax-Free Cash
Up to 25% of the fund value (up to the lifetime limit) can be taken as tax-free cash. Whether this can include the value of contracted-out benefits is still to be determined.
Retirement Income
The remaining fund (after tax-free cash has been taken) must be used to provide an income in one or more of the following ways:-
- Secured benefits – a guaranteed income (annuity purchase or promise from employer)
- Alternatively Secured Pension (ASP) – introduced to meet needs of religious groups that cannot take other options because of pooled mortality risk
- Unsecured benefits – a non-guaranteed income (new form of drawdown)
The income from unsecured benefits is subject to no minimum and a maximum of 120% of the annual income available from a single life, level annuity on the open market, reviewed at least every 5 years. Alternatively part of fund can be used to purchase a limited term annuity not exceeding 5 years. The income from ASI will also be subject to no minimum limit but maximum will be 70% of the annual income available from a single life, level annuity on the open market, reviewed at least every 5 years.
Trivial Commutation
Individuals will be able to commute small pensions valued in total (including cash option) at less than 1% of the lifetime allowance and where all such commutations occur with a single 12 month period between the individual’s 60th and 75th birthday. 25% of the fund will be tax free the balance taxed as earned income.
Ill Health
All schemes can provide benefits early in the event of incapacity. If life expectancy less than one year benefits may be fully commuted – no tax charge if within lifetime allowance.
Death Benefits
There will be no limit on the lump sum death benefit that can be paid before taking benefits. The amount up to the lifetime allowance will be payable tax free.
Any excess lump sum will be subject to a 55% recovery charge.
Dependant’s pensions
Dependant’s pensions may be provided without limit, in addition to or instead of a lump sum. However, the value of dependant’s pension is secured either by guarantee under the scheme rules or by annuity purchase or by alternative secured income (ASI). There can be no guaranteed period and no provision for value protection.
The definition of “dependant” will follow current rules, i.e. Spouse and minor children will automatically qualify.
At the discretion of the scheme trustees/administrator anyone who was dependent upon the member at the time of death, i.e. someone dependent due to disability, someone financially dependent, including financial interdependence.
A pension to a spouse or adult dependant can be payable for life or, in accordance with scheme rules, may cease on remarriage/marriage.
A pension to a child must cease when the child attains age 23 unless he/she was dependent due to disability.
Death after vesting
The benefits payable in the event of a member’s death after vesting depend on whether his pension is unsecured (i.e. income drawdown fixed term annuities) or secured (i.e. guaranteed under the scheme rules, annuity or ASI).
Unsecured
If a member dies during drawdown before age 75 the benefits payable to his/her dependants are either
A lump sum equal to the remaining fund value less a 35% tax charge or
Dependants’ pensions which can be drawn from the fund.
Dependants’ pensions will be payable subject to the following provisions –
- No minimum income level.
- Maximum income in any year will be 120% of the annuity that could be purchased for the dependant.
- The maximum income will be reviewed every 5 years.
- Drawdown must cease by the dependant’s 75th birthday.
- The dependant can purchase an annuity with all or part of the fund at any time.
- At age 75 the pension must be secured.
If a member is taking income by means of a term certain (limited term) annuity then, in the event of death, and assuming funds have been fully vested, the balance of the fund will be treated in the same way as would the residual funds in a drawdown arrangement, i.e. full refund less 35% tax.
No lump sum is payable from the term certain annuity.
Secured
If a member’s pension is secured the options on death before age 75 are –
The remaining instalments under a guaranteed period of up to 10 years, the period commencing on the date when benefits first vested. For example, if a member initially opts for drawdown and purchases an annuity after 6 years, then the maximum guaranteed period allowed under the annuity is 4 years.
Value protection, as proposed in the first consultation paper, whereby a lump sum can be paid equal to the initial investment/purchase price less the pension instalments paid. The lump sum will be subject to a 35% tax charge.
Dependants’ pensions (without guarantee period or value protection) which can be taken in any of the following forms;guaranteed by pension scheme/arrangement; annuity; ASP.
Unsecured income (drawdown) but only up to the dependant’s 75th birthday
A guaranteed period and value protection are “mutually exclusive”, meaning that you cannot have both and you cannot switch between the two.
Where a guaranteed period applies and a dependant’s pension is payable the dependant can choose to defer the dependant’s pension until the end of the guaranteed period.
If a member dies after age 75 the only benefit that can be provided is a dependant’s pension (in any of the forms outlined above). No lump sum will be payable either directly or indirectly, no matter the source of the pension. If a member draws his pension under ASP and dies after age 75, leaving no dependants, the remaining fund will either be used to increase benefits for the remaining members in the scheme or will be treated as a surplus. Alternatively the Government suggests that the member may wish to leave the fund to a charity of his/her choice.
Inheritance Tax
If lump sum death benefits are payable at the discretion of the scheme trustees/administrator they will be, as at present, outside the member’s estate for IHT purposes.
Pensions and Divorce
New pension credits after A-Day will count against recipient’s lifetime allowance. Pre A-Day pension sharing orders, when calculating pre A-Day rights, the value of any pension allocated to spouse will be ignored for the purposes of both spouse’s lifetime allowances.
Investments
After A-Day all pension schemes will be allowed to invest in all types of investments including residential property. Any non-commercial use of an asset ( i.e. where a member lives rent-free in a house owned by the pension scheme) will generate a tax charge on the member as a benefit in kind.
Shares in sponsoring employer will be restricted to 5% of fund value. Loans up to 50% but not to scheme members. Pre A-Day investments not affected.
Scheme borrowing will be restricted to 50% of fund value subject to DWP requirements, which may be more restrictive.
Transitional Arrangements
Transitional rules will apply to protect entitlement to greater benefits then would be available under the new regime in respect of fund value, and tax-free cash.
Fund Value
Two options available :-
Primary Protection – where funds at A-Day exceed £1.5M. The higher value is registered as a percentage of £1.5M and that percentage is applied to the lifetime limit when benefits are taken. Any amount over this will be subject to the recovery charge.
Enhanced Protection – Can be used for any sized funds but active membership must cease prior to A-Day and no further contributions can be made after A-Day (including contracting-out rebates to a personal pension but not a COMP). Total fund whatever value at retirement date will be exempt from recovery charge. If contribution paid protection reverts to Primary if applicable.
Cash Sum
Primary Protection – the pre A-Day entitlement will be indexed in line with the lifetime allowance up to date benefits are taken.
Enhanced Protection – the pre A-Day entitlement will be expressed as a percentage of pre A-Day fund value and same percentage will be applied to increased fund value when benefits are taken.
Where individual has pre and post A-Day service he can receive lump sum based on pre A-Day service plus 25% of fund based on post A-Day service.
The transitional rules are far from simple and should be looked at on a case by case basis.
Miscellaneous
Current drawdown arrangements must switch to new basis by the next triennial review following A-Day.
The tax charge on refunds of contributions to members leaving an occupational scheme with less than 2 years service will be 20% on the first £10,800 and 40% above.
Tax will be deducted as at present from the refund.
Feature Created: 2007-10-11
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