8th July 2015
A reduction in pension tax relief for higher earners widely trailed in the Budget could lead to a reduction in effective tax relief of 67.5% warns David Smith, Financial Planning Director at Tilney Bestinvest.
In note issued this morning, he says: “One policy that it widely expected to be confirmed is the cut in pensions tax relief for those with an annual income in excess of £150,000, with the additional tax revenue raised used to offset the proposed increase in inheritance tax limits. Here we look at the proposals in greater detail and examine what the actual impacts might be to those who are affected.
The Institute for Fiscal Studies data has identified that there are currently circa 300,000 individuals in the UK who receive taxable incomes that exceed £150,000 per annum, so this proposed change will only affect a relatively small proportion of the working population. Smith says these individuals are already subject to income tax at 45% on earnings that exceed £150,000 and if national insurance contributions of 2% are taken into account, they already only effectively receive 53p of every pound earned above £150,000.”
The current rules
Smith says: “Under current pension legislation these individuals (there is an exception where income is being taken from pension drawdown already) can contribute up to the ‘Annual Allowance’ of £40,000 per tax-year, with Income Tax relief available at their highest marginal rate of tax. Furthermore, they are able to carry forward unused ‘Annual Allowances’ from the previous three tax-years; resulting in the maximum potential contribution of up to £180,000 available in the current tax-year (the maximum would be lower if the individuals’ total income was below this amount). However, in this instance I am assuming that the individual has been maximising pension contributions and no carry forward allowances are available.
“Let us take the example of an individual who earns £190,000 and opts to contribute the maximum £40,000 (gross) ‘Annual Allowance’ into their pension arrangement. They would immediately receive 20% basic rate tax relief at source and would therefore only need to actually contribute £32,000 (net). They would then be able to claim a further 25% tax relief on this payment through their annual tax return, and this is achieved by increasing their basic rate tax threshold by the £40,000 (gross) pension contribution, resulting in no income actually being subject to tax at 45%. The total tax relief available would be £18,000 making the effective cost to this individual only £22,000, representing tax relief of 45%. This is an extremely efficient way for the individual to fund their eventual retirement.
“Some may argue that it is unfair for an individual to receive 45% tax relief on pension funding, but let us not forget that the eventual pension income withdrawn will be subject to income tax, with the exception of the 25% lump sum that can currently be withdrawn tax-free. Furthermore, due the effective cap on tax relieved pension funding provided by the ‘Lifetime Allowance’, individuals will face an effective tax charge of 55% on any excess value above £1.25m, and this will reduce to £1m from 6th April 2016.”
The proposed rules
Smith says the expected changes would see a reduction in the ‘Annual Allowance’ of £40,000 for those with incomes that exceed £150,000, on a tiered basis to a minimum of £10,000 once incomes exceed £210,000. This would effectively mean that for every £1 of income earned between £150,000 and £210,000, the individual would lose 50p of ‘annual allowance’. It is anticipated that this change could become effective in April 2017, but could be sooner.
Smith adds: “If we revisit the example of the individual earning £190,000, then their ‘Annual Allowance’ would reduce to £20,000 under the proposed system. They could still opt to contribute £40,000 into their pension, but would only receive tax relief on £20,000, with the £20,000 above the ‘Annual Allowance’ subject to an Income Tax charge of 45%; so 50% less tax relief.
“However, it gets worse; based upon a continued gross contribution of £40,000 the tax saving of £9,000 represents tax relief of only 22.5%, meaning that the effective marginal rate of Income Tax on every £1 of income earned between £150,000 and £210,000 will work out at 67.5% (source; Institute For Fiscal Studies).”
What are the options?
Smith says if the individual funds their pension personally, then they have the straightforward choice of either reducing contributions to match their revised annual allowance or continuing to make pension payments at the current level and incur the effective marginal rate of tax of 67.5% on income received between £150,000 and £210,000.
He says: “The situation is less straightforward if the employer is funding some or all of the pension payments as, in the event that they request their employer to cease making the payments, there is no guarantee that they will increase their salary by an equivalent amount. Indeed, given that employers would be subject to National Insurance contributions of 13.8% on salary, it is highly unlikely that they would opt to increase salary on a 1 for 1 basis.
“Historically this situation could potentially be avoided by simply opting into a salary sacrifice arrangement with your employer to reduce your salary below the £150,000 level, with the employer then making a pension payment equivalent to the amount sacrificed. So, in our example the individual would sacrifice £40,000 of their salary and receive a reduced salary of £150,000, their employer would contribute £40,000 into a pension on their behalf, and they would effectively receive 45% tax relief. However, it is widely anticipated that the Chancellor will make provision to prevent this type of sacrifice arrangement being introduced, otherwise the exercise would seem somewhat fruitless in trying to increase the tax take to the Exchequer.”
Are there any tax efficient alternatives to pensions?
“This reduction in tax relief is likely to make funding either Venture Capital Trusts (VCT) and/or Enterprise Investment Schemes (EIS) more attractive to the individuals who are affected. Smith adds: “Ultimately, as a result of these expected changes, the requirement for good financial and tax planning will become even more important for those affected. The ability to fund for retirement does not only have to be achieved through a pension arrangement, and a broad spread of assets (i.e. ISA, OEICs and Offshore Bonds etc.) should be utilised to enable a tax-efficient income to be generated in retirement.”