Planning for A-Day (The new pension tax rules)

Asoka Karandawala FCA outlines the new pension tax rules which came into effect on 6 April 2006, the main aims of which are to simplify the UK pension regime and encourage greater pension investment

The 6 April 2006, also known as “A-Day”, saw the most radical overhaul of the UK pension tax rules in the last 50 years. The new regime proposes to simplify the existing 3000 pages of regulations and 8 sets of rules and the aim is to encourage greater pension investment.

Main changes

• Individuals will have an annual allowance and a personal lifetime allowance which replace the current limits on contributions and benefits together with a single tax regime for all pensions; 
• Individuals will now be able to invest their pension fund not only in quoted shares but in commercial property and unquoted shares;
• Individuals will be able to take a tax free lump sum of 25% of the benefits in their fund irrespective of their current pension arrangements;
• Individuals will be able to defer buying an annuity past the age of 75 and it may be possible to transfer the funds to their dependants after their death and that of their spouse – to enable another generation to provide for their retirement; and
• Members of occupational schemes will not have to retire from their employment to take a pension, so benefits can be taken whilst working for the same employer.

Annual & Lifetime allowances

From 6 April 2005, each individual will have a personal annual allowance rising from £215,000 for 2006/7 to £255,000 by 2010/11. If an individual contributes more than that in any one year, the excess will be taxed at 40%. Tax relief will be given for contributions on 100% of earnings up to the annual allowance.

As far as drawing benefits, there will be a lifetime allowance of £1.5million, rising to £1.8m by 2010/11.  This is the value of the pension savings when an individual’s funds are ‘crystallised’ – namely when they draw their pension. If the fund exceeds this allowance, the individual will be taxed at a special rate of 55% on any lump sum cash taken out and at 25% of any excess income taken as pension income.

For most individuals, these allowances would be more than adequate. However, there are individuals who may already exceed the £1.5million lifetime allowance or would be approaching the limit, which will have tax implications. Protection is available as long as the individual applies within 3 years of A-Day, but they should seek independent professional advice before 6 April 2006 as they may have to make a decision on the protection required before that date.

Pension Investments

The previous restrictions are lifted and the individual has a wider choice of what to invest in. The new rules allow self invested personal pensions (SIPPs) to invest in commercial properties and also unquoted shares. The choice was even wider with residential properties, buy to lets, fine wines and other exotic items allowed until the Chancellor’s U-turn on 5 December 2005 in his pre-budget report, making such items ‘prohibited’ and subject to punitive taxes.

As for commercial property, it will also be possible for the pension scheme to borrow up to 50% of the scheme’s asset value to purchase an asset compared to the current rule of up to 75% of fund assets. This will be useful for many business owners to have their pension fund own the property their business operates out of. All future income and capital gains from the property can then be protected from tax within the pension fund.

However, if an individual wants to transfer an existing personal asset to his/her pension fund, there are legal and tax implications to take into account before proceeding.

For example, transferring an existing commercial property will be deemed a ‘disposal’ and any gain accrued from the date the individual originally bought the property to the date transferred to the pension fund will be chargeable to Capital Gains Tax. Also, any pension fund assets used by the individual personally will be deemed a ‘benefit in kind’ and taxed if the individual does not pay commercial rates for the use of those assets.

Individuals will also be able to arrange for life assurance cover for the family within their pension funds which will get tax relief on the premiums paid.

Asset transfers and investments will need professional tax and financial advice to give individuals the best benefits, remembering always that any investments are meant to provide for their retirement.

Tax free cash

Regardless of the scheme, individuals will be able to take out 25% of their pension fund value on the benefits built up after A-Day. This would mean 25% of the lifetime allowance, which would be £375,000 in 2006/7 (25% of £1.5m).

Also, if an individual has the option of taking more than 25% under their current pension scheme, he/she may be able to protect this provided that they take action before 6 April 2006.

Retirement – the new options – alternatives to annuities

Currently, individuals have to purchase an annuity from an insurance company with their pension fund by the age of 75 and this would continue to pay an income to their spouse or dependants on the individual’s death. On the death of that nominated person, however, the insurance company retains any remaining funds.

With the new rules, individuals have greater flexibility and more options.

Individuals can use part of their funds to buy short term, 5 year annuities named ‘Limited Period Annuities’ and leave the balance of funds invested,. There will also be ‘Value Protected Annuities’ which if the individual dies early, will re-absorb any balance back into their pension fund (after a tax charge of 35%). However, if the individual takes this option, they cannot take a tax free cash lump sum.

Alternately, up to age 75, individuals can take an ‘Unsecured Pension’, which is income drawdown after the individual has taken the tax free lump sum and leave the balance invested in the pension fund. There is no minimum amount and the maximum amount taken will be up to 120% of a single life annuity. If the individual dies before 75, their spouse can inherit the fund and draw an income or anyone nominated can take a lump sum benefit after paying 35% tax.

At age 75, individuals can buy an annuity or take an ‘Alternatively Secured Pension’, which gives the option of deferring buying an annuity past age 75. It operates as a form of income drawdown and on the individual’s death, his/her spouse or dependants can buy an annuity. The maximum drawdown allowed is 70% of a single life annuity. Any unused funds can be passed on to other family members of the scheme to provide for their retirement. However, HM Revenue & Customs has stated that such transfers after death between family members will be subject to Inheritance tax.

Occupational schemes

The annual and lifetime allowances and single tax regime will also apply to individuals in an occupational scheme (an employer’s defined benefit fund) and certain ratios will apply to how much contribution the individual and his/her employer can make to the scheme. As for the 25% tax free lump sum, some occupational scheme trustees may have to alter the rules.

Retirement age

The minimum age that an individual can take a pension will be age 55 by 2010.

Example

Mr Smith earns £70,000 per year from his business and has a personal pension fund valued at £250,000.  He also has 10 years service in an occupational scheme from when he was previously employed. He owns the offices his business operates from which he bought in 2003 for £100,000 which is now valued at £150,000. 

• In 2006/7, he can contribute the full £70,000 to his pension fund making the value £320,000 and saving income tax of about £22,000 for 2006/7;
• He can sell the offices to his pension fund for £150,000 (which can borrow the cash if required up to 50% of the fund value), which saves future capital gains tax and income tax on the rental income;
• Mr Smith will have a personal capital gains tax assessed on the sale of the offices;
• He can repay any mortgage on the offices and capital gains tax from the proceeds;
• He improves his Inheritance Tax position due to the offices being transferred to his pension fund; and
• He will have to take professional advice at the outset and also see whether it is worthwhile getting a transfer from his previous occupational scheme.

Asoka has held several senior finance posts in businesses for 20 years and now runs a consulting practice to help more businesses achieve their financial goals. His company offers a Finance Director Service to businesses that do not need a full time FD. You can contact him at: Asoka Karandawala FCA, AKCA Consulting  Chartered Accountants & Business Advisers,  Tel: 020 8487 0483  Email: asoka@akca.co.uk Web: www.akca.co.uk

The contents of this article does not constitute financial or legal advice.  The content is not intended to be used as a substitute for specific financial advice. No recipients should act or refrain from acting on the basis of this article without seeking appropriate professional advice.