Final salary pension savers must make sure they don’t breach the Chancellor’s new tax limits

13th December 2012

Chancellor George Osborne’s Autumn Statement will punish many high and middle income pension savers with massive new tax charges, although there was a silver lining for retirees in income drawdown writes pension journalist John Greenwood.

The bad news in this month's mini-Budget all related to pension allowances, which are the amounts you are allowed to save in a pension and benefit from tax relief of up to 50 per cent. There are two main allowances – the lifetime allowance and the annual allowance, and in what you might call a spirit of fairness the Chancellor has decided to cut them both.

This means from April 2014, the maximum you can save in a pension and still get tax relief in your lifetime is now £1.25m, down from £1.5m today and even that is down from £1.8m a couple of years ago. Likely to affect more people is the cut in the annual allowance, the maximum you can stash in your pension in any tax year, which is being cut to £40,000 from £50,000. Osborne is predicted to save £1bn a year from the changes, and people in final salary schemes are set to feel most of the pain.

A £1.25m pension pot, or a £40,000 annual contribution may sound like a lot, but if you are in a final salary scheme you could easily find yourself busting this new limit and facing a whopping 55 per cent tax charge on the excess.

This is because the limits relate to the cost of buying the income, not the income itself. Defined benefit income is multiplied by a factor of 16 for the purposes of calculating whether you have breached your annual allowance. An increase in benefits of £1,000 is therefore treated as a contribution of £16,000, because, very roughly speaking, this is what such an income is worth in pure cash terms.

So an increase in defined benefit pension income of £2,500 is all it takes, multiplying it by a factor of 16, to hit the £40,000 annual contribution allowance.

Even accruing another £1,000 income by virtue of simply having worked for another year eats up £16,000 of your £40,000 annual allowance. Getting a pay rise as well can easily take you over the limit. For example, someone earning £45,000 in a scheme that gives one sixtieth of final salary for each year of service, and who has already accrued 30 years' benefits, will in future be hit with a 55 per cent tax charge if they get a payrise of £4,000 or more. Higher earners will see their pensions taxed for even smaller percentage pay rises.

It is not just people in defined benefit schemes who are likely to be hit by this reduced tax charge. Big contributions into defined contribution pensions, of the sort typically made by people with fluctuating income or self-employed people in the years before retirement, are also restricted on account of the Chancellor's less generous pension regime, which is why experts recommend making the maximum contributions possible in each tax year.

The pain of these changes is lessened for both defined benefit and defined contribution savers by the fact that you can carry forward any unused allowance from the previous three previous years.

And it's not just annual contributions that are being cut. The total amount you can save in your lifetime is also being reined in from £1.5m to £1.25m.

Just to make things complicated, defined benefit income is multiplied by a factor of 20, not 16, for the purposes of working out whether you have breached the lifetime allowance. This means the maximum tax-free defined benefit pension anyone is allowed is now just £62,500. If your overall pension entitlement exceeds the lifetime allowance you are looking at a tax bill, again at a rate of 55 per cent on the excess. This is even the case if you only breach the limit because the funds you invest in perform spectacularly well.

If you are close to this limit then you should seek out more detailed information about how to manage your contributions and investment strategy to make sure you do not pay tax unnecessarily.

The one group of pension savers taking something positive from Osborne's autumn statement are the 400,000 people in income drawdown, who have, in the last few years seen their incomes shrink as a result of the Bank of England's policy of printing money and tighter government controls on their withdrawals.

Income drawdown investors are restricted in how much they can withdraw each year, to stop them spending their fund too quickly and being left with nothing to live on.

Currently you can withdraw an amount equal to the income you would get if you used your fund to buy an annuity, as prescribed by a formula set by the Government Actuary's Department (GAD).

In future that limit is being increased by 20 per cent, meaning drawdown investors can take a fifth more income than they can today. But cash-starved income drawdown investors don't yet know when they will be able to break out the champagne because the Treasury hasn't actually said when these new higher withdrawal limits will take effect. Changing this limit requires primary legislation, which means it might not happen until June 2013.

Maybe cava is more appropriate than champagne – Osborne's gift is not that generous. It simply puts drawdown investors back in the position they were in back in 2011 when withdrawal levels were reduced from 120 per cent to 100 per cent of GAD rates because of fears investors would erode their pots too quickly.

Since then quantitative easing has pushed gilt yields and the GAD rates they are linked to so far that all but the most pessimistic investment experts believe the new, more generous withdrawal rates are suitable. Good news is hard to find in the world of pensions, so you have got to take it when where you can.


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