Make the most of pension reliefs now – further changes likely after general election

Tue 07 Oct 2014

Politicians in both parties which make up the coalition have announced proposals to change tax aspects of pensions.

Conservatives will reduce or eliminate tax charge on unused DC funds at death

The eye-catching announcement at the conservative party conference is a replacement regime for the 55% tax charge on undrawn pension funds at death.  Under the new regime:

• if the deceased had not reached their 75^th birthday, paid tax free to the beneficiaries, and
• if the deceased was 75 or older at death the payment of remaining funds will be treated as taxable income of the beneficiaries as and when withdrawn (and thus the maximum rate of tax will be 45%).  There will also be the option for the beneficiary to withdraw the whole pension as a lump sum, subject to a 45% charge.  (However, the Government proposes to change this from 2016/17 so that lump sums would also be taxable at the marginal rate.)

The announcement implied the new regime will apply to deaths on or after 29^th September 2014, provided payment out of the pension fund is delayed until after 5 April 2015.  There is no restriction on who can be a beneficiary.

Note that this change is of relevance only to defined contribution pension schemes (such as personal pension schemes) where the beneficiary has either not taken any decision as regards benefits or is taking them by way of drawdown.  It will have no effect where the deceased used DC funds to buy an annuity (unless the annuity has a guarantee period and the member dies before the expiry of that period), or is taking a scheme pension.  Nor is it of any relevance to defined benefit (DB) schemes.   People who are retiring will have much greater flexibility than before, and now have the potential to pass on pensions pots free of IHT.  However, making the wrong choice could have a profound effect, so it is important the tax implications of the various options are carefully thought through.

Lib-Dems propose changes to tax relief on contributions

The Lib-Dem party published draft proposals for their May 2015 general election manifesto.  Although they are the smallest of the three main Westminster parties their proposals may be significant.  There is a realistic possibility the Lib-Dems may be part of another coalition and also their proposals in this area are likely to be adopted by the Labour party.

The two proposals in their policy paper on tax relief for contributions to pension schemes are:

• commitment to reduce lifetime allowance to £1m
• consult on one rate of tax relief for all.

Lifetime allowance

This allowance is currently £1.25m (until 5 April 2013 it was £1.8m, then £1.5m until 5 April 2014).  HMRC reckoned the reduction from £1.8m to £1.25m would immediately affect 140,000 individuals and ultimately up to 360,000.  A reduction of the allowance to £1m will affect many, many more.

Tax relief for pension saving

This issue is regularly raised.  The exact words in the Lib-Dem publication are: “Establish a review to consider the case for, and practical implications of, introducing a single rate of tax relief for pensions, which would be designed to be simpler and fairer and which would be set more generously than the current 20% basic rate relief.”   Elsewhere they have suggested the rate may be 30%.

A big obstacle to devising a workable solution is how to deal with accruing benefits under final salary (DB) schemes, most of which are state sector gold plated schemes.  First there is the political impact of restricting the rate of relief affecting what is now a vast number of employees who are already higher rate taxpayers.  Secondly, those with income just under the higher rate limit and the benefit of accruing pension rights pushes them into higher rate will find themselves with a tax liability. Thirdly, and possibly of greater complexity, is the mechanism for giving basic rate taxpayers in DB schemes an additional tax allowance.  The measure of pension input for DB schemes is a calculation based on the increase in prospective benefits (it is not the employer contributions).  To put DB members on a par with DC a mechanism will have to be found to give DB members an additional tax relief.  The amounts involved will be small but could involve a lot of work possible also requiring low earners to submit tax returns.  Pension businesses are already reeling from the administrative upheaval preparing for the April 2015 changes and putting onto this the burdens of implementing a system to give additional relief to basic rate taxpayers will be huge.

Review the level of your pension saving

Both political parties’ policy suggestions give yet more impetus to encourage all to review the level of their pension saving.

If the Conservatives’ changes are implemented as they are believed to be, undrawn pension funds will become a significant tool in all inheritance tax planning.  The pension pot provides easily accessible funds yet if unused will pass tax free to beneficiaries.  The implication is that default IHT advice will be to use up all other funds before touching assets held in a pension fund.

If that is not enough the Lib-Dem proposal is particularly important for those who currently have DC pension saving of between £1m and £1.25m.  Arguably they should consider making the most of their annual allowance.  Going on the basis of previous reductions in the annual allowance those with saving will be given a way to protect their saving in excess of £1m.

As regards the Lib-Dem longer term proposal for a single rate of tax relief, if a way is found to deal with the huge complexity then those liable to tax at the higher or additional rate whose saving is below the lifetime allowance should maximise contributions.