Introduction
This guide sets out some of the main changes; the benefits; the contributions allowed; and the way they are treated for tax. As there are several thousand pages of regulations, it is impracticable to cover every aspect in this Factsheet and there is no substitute for seeking personal guidance from a suitably experienced Financial Adviser.
Although this Factsheet mentions the treatment of various defined benefit arrangements, it is written with its main focus for people with pension benefits in a defined contribution (money purchase) arrangement.
Prior to A-Day, pensions had been governed by eight different tax regimes, introduced over many years of pensions’ legislation. Each tax regime had different rules in respect of contribution amounts allowed and the benefits that could be taken at retirement age. The set of rules applying to an individual would depend, amongst other things, upon the type of pension scheme he chose to join, and the date he started making contributions to it.
The greatest simplification applies to money purchase arrangements.
Pension simplification has replaced these eight regimes so that all forms of scheme are governed by one (albeit huge) set of regulations.
There is now no limit on the amount you can save in pension arrangements, or in the amount of benefit you can take from them. But if you contribute over a certain limit (the annual allowance), you will not receive tax relief on those contributions above that set allowance. Furthermore, if you have a very large pension benefit, you may also have to pay a penal rate of tax on the amount of benefit above the benefit allowance (the lifetime allowance).
For the vast majority of scheme members these upper limits will have little or no impact. However, they may well affect those where they or their employer are able to make very large contributions to schemes on their behalf or who are on high salaries and enjoy generous employee benefits.
Types of Pension Plan
Since A-day, (6th April 2006), the number of different types of pension scheme available and the rafts of legislation previously applicable to them has been reduced to two main types of scheme:
- money purchase (also called defined contribution) and
- defined benefit (also called salary related).
Both types of scheme, previously approved by the Inland Revenue under one of the many earlier regimes, are now called registered pension schemes.
A money purchase scheme accumulates a ‘pot’ of money or other assets by investing the contributions made to it. The resulting fund in the pot at retirement date is used to pay any lump sum and provide an income (a pension). This is now the most common method used to build up a pension in the private sector.
A defined benefit scheme sets out a formula that calculates how much pension and/or lump sum you will receive. Although many of these schemes still exist, the number of active members in them will be contracting in the future as many sponsoring employers have chosen to close their scheme so that new employees are unable to join. Other employers have chosen to go a step further and close their defined benefit scheme to all members, including current employees who are usually then given a money purchase scheme as an alternative.
Some defined contribution arrangements may have an element of defined benefit within the overall scheme design.
A member of a defined contribution scheme can now consider participating in any other form of registered pension scheme or any number of money purchase schemes whilst continuing to contribute to that arrangement.
Lifetime Allowance
A-Day, (6th April 2006), introduced a threshold to the amount of pension benefit you can receive over your lifetime above which there is a tax charge.
The standard lifetime allowance is the maximum value of benefits that an individual can draw over their lifetime without attracting severe tax rates on the excess benefit. For the tax year 2006/2007 the figure was set at £1.5 million. This figure will increase each tax year up to £1.8 million in the tax year 2010/2011, and will be reviewed every 5 years after that:
- 6th April 2006 £1.5 million
- 6th April 2007 £1.6 million
- 6th April 2008 £1.65 million
- 6th April 2009 £1.75 million
- 6th April 2010 £1.8 million
The lifetime allowance includes all of your pension arrangements combined, whether money purchase or defined benefit (but does not include your state pension benefits). It does however include all benefits from previous employments or periods of self-employment.
If all benefits are in money purchase arrangements, the application of the lifetime allowance is fairly straightforward:
Has the value of all the funds reached the standard lifetime allowance?
As many employees will have some of their benefit provided by a defined benefit scheme(s), to check against the lifetime allowance the annual pension held in those schemes is converted into a monetary value and added to the money purchase ‘pot’.
HM Revenue and Customs (HMRC) has determined that the calculation to work out this value should be to multiply the annual pension by a factor of 20:1 (this factor is 25:1 for those pensions that have already started being paid). A defined benefit scheme must use a higher factor where such higher amount has been agreed with HMRC.
Example
Joe has a pension of £30,000 p.a. from his defined benefit scheme, the XYZ Pension Scheme, which he started receiving in September 2005 (i.e. before A-Day, 6th April 2006).
He also has a money purchase ‘pot’ under another scheme, the ABC Pension Scheme, which was valued at £150,000 when he reached his retirement age. He started taking this new pension in February 2007.
In February 2007, the XYZ Pension Scheme administrators will have checked any benefits Joe had received so far, plus the benefits he was about to receive, against the appropriate tax year’s lifetime allowance figure (which was £1.5m for 2006-2007).
His XYZ Pension Scheme pension benefit would have been valued at:
£30,000 x 25 = £750,000
He had therefore used up 50% of his lifetime allowance (£750,000 is 50% of £1.5m).
His ABC Pension Scheme pension benefit would have been valued at:
£150,000
This pension benefit used up 10% of his lifetime allowance (£150,000 is 10% of £1.5m).
This means he had only used 50%+10% = 60% of his lifetime allowance.
As his benefits were below his lifetime allowance, no additional tax charges were applied.
Joe will have received a certificate from the ABC Pension Scheme when he started to take his benefits, confirming that he has used 60% of his lifetime allowance.
If Joe has other pension benefits in yet another arrangement, at the time he is due to draw those benefits, he must produce his certificate from the ABC Pension Scheme, stating he has already used 60% of his lifetime allowance.
All checks to find out if you have exceeded your lifetime allowance are made by your pension scheme or pension provider when certain events happen to you or your pension benefit. These are known as benefit crystallisation events (BCE).
There are 8 types of BCE, the most important being:
- the date you choose to receive all or part of your benefits from your scheme
- where some types of lump sum are paid
- when you reach 75 without having drawn all your benefits.
These are only a few examples. The scheme administrators will seek information from you and investigate if they believe that a BCE has occurred, or is about to occur. They must assume that whenever any benefit is paid in any form that a BCE has arisen. Only by reference to the HMRC regulations can this be confirmed.
If you wish to investigate how near you are to reaching your lifetime allowance, you should seek financial advice. This could be a time consuming calculation, as any pension arrangement you have held throughout your lifetime must be taken into account.
Lifetime Allowance Charge
What if you exceed the lifetime allowance?
If the total value of your pension benefit exceeds your lifetime allowance when a BCE occurs, you will have to pay a lifetime allowance charge (i.e. you will be taxed) on the amount over your lifetime allowance.
If that BCE leads to the payment of a lump sum, you will be charged 55% tax on that part of the lump sum that exceeds your lifetime allowance.
If that BCE leads to the payment of a pension, a 25% tax surcharge is imposed on the excess over your lifetime allowance. Your pension is taxed at your normal tax rate. As individuals who breach their lifetime allowance figure will probably be in the 40% tax bracket, this would equate to 55% tax on the ‘excess’ pension (the 25% tax surcharge on the net pension of 60%, reduces the net pension to 45% which is equivalent to a tax rate of 55%).
Protection (Enhanced and Primary)
There are a number of people who have reached (or are concerned about reaching) their lifetime allowance limit because of arrangements in place before April 2006.
Transitional rules allow scheme members to protect these benefits.
Two types of protection are available:
Enhanced Protection
Is available to those members of pension schemes who think their benefits may have exceeded the lifetime allowance at A-Day or expect that they will do so at some stage later. It doesn’t really matter whether the lifetime allowance has been reached or not at A-Day.
Registering for enhanced protection ensures an individual will not be liable to a lifetime allowance charge when a BCE occurs, providing no further contributions are made to money purchase-type arrangements after A-Day. So, it would not be possible to seek enhanced protection and continue to pay AVC or personal pension contributions
For a member of a defined contribution scheme, all the pension funds belonging to the individual at A-Day (including previous pension rights in a defined benefit and all defined contribution arrangements) must be registered with HMRC, and no further contributions can be made to any of these schemes.
Primary Protection
This is only available to individuals whose benefit value had already exceeded £1.5 million at A-Day. The individual must register his/her protection and the value of the fund at A-Day with HMRC, who will calculate a personal lifetime allowance figure for that person.
If say, John Smith had total pension assets valued at £3m on 6th April 2006, his personal lifetime allowance will be twice the standard allowance (£3m is 2 x £1.5m, the standard lifetime allowance for 2006/2007). The value of John’s pensions will be allowed to increase in proportion to the increase in the standard lifetime allowance up to the benefits crystallisation event. Any benefit value over this threshold will be subject to the lifetime allowance charge in the same way as enhanced protection.
Where eligible, an individual with funds exceeding the lifetime allowance at A-Day (£1.5m), can register for both enhanced and primary protection if they wish. This allows for future changes in circumstances where the individual has stopped contributions in anticipation of taking advantage of enhanced protection. They can either fall back on the primary protection if that is more effective, or start paying contributions again if say the pension value falls below the lifetime allowance.
With either type of protection, you still have until 5th April 2009 to register that protection with HMRC.
Annual Allowance
The complicated old rules have now been replaced with one rule governing the total amount you and your employer are entitled to contribute into all of your pension schemes combined. The annual allowance is the maximum amount of those pension contributions upon which an individual can enjoy tax relief in a particular tax year.
There is no limit on the amount individuals and their employers can contribute; it’s just that you don’t receive tax relief on contributions over the annual allowance.
You can contribute:
- up to 100% of your earnings, or
- £3,600, each year and receive at least standard rate income tax relief on those contributions - even if you are not earning. This means that anyone can pay £2,808* into a pension (which would currently equate to paying in £3,600 after tax relief), even if they don’t pay tax.
(* in 2007/8. In 2008/9 the amount rises to £2,880 with the reduction in the standard rate of income tax).
This is subject to an annual allowance figure of £225,000 for the tax year 2007/2008. Any contributions made which exceed the annual allowance will trigger an annual allowance charge which is a tax of 40% on the excess contribution (even if you normally only pay basic rate tax).
The annual allowance was £215,000 for the tax year 2006/2007. The figure for current and future years will be as follows:
- year commencing 6th April 2007 £225,000
- year commencing 6th April 2008 £235,000
- year commencing 6th April 2009 £245,000
- year commencing 6th April 2010 £255,000
The annual allowance figure will be reviewed after that date.
However, the annual allowance limit will not apply in the year in which you actually start taking your benefits. You will still be limited by the 100% of earnings limit but this allows for the possibility of making very large contributions just before retirement. Because of the earnings limit on tax allowance, careful planning of the incidence of earnings is required to maximise the benefit of this concession. As few people will retire on 5th April earnings and contributions should be spread carefully over the last year of employment taking account of the relevant tax years involved.
For money purchase arrangements, the amount of contributions made is the total of all contributions made by you, or on your behalf, and is therefore easy to check against the restrictions noted above.
You should always be mindful that any contributions made to your pension arrangements may take your total pension savings above your lifetime allowance figure. An experienced Financial Adviser will be able to discuss this with you and help you to plan practical ways of saving for your retirement.
If your annual contribution is more than the maximum allowed for tax relief purposes, you will face a personal tax charge where relief has been granted by the scheme. This is of particular significance to active members of defined contribution schemes where a large salary increase could give rise to a large contribution by the employer.
Tax Free Cash
There are a number of ways that a lump sum may be payable from a registered pension scheme. One of these is the cash lump sum at retirement, commonly referred to as a tax free cash lump sum. The term used by HMRC since 6th April 2006 is a pension commencement lump sum.
Prior to A-Day, the rules governing the maximum amount of tax free cash a scheme member could enjoy, were incredibly complex, although most money purchase schemes used a simple formula (such as a percentage of your pension ‘pot’).
Subject to the rules of your scheme, the maximum lump sum allowed is 25% of the fund value, up to an overall maximum of 25% of the lifetime allowance. Any lump sum payment over this figure would be subject to severe tax rates (up to 55%).
For the tax year 2007/2008 the overall maximum tax free lump sum would be 25% of £1.6 million = £400,000.
The lifetime allowance includes the value of benefits in any registered pension scheme. This includes AVCs and FSAVCs from which, previously, you were not allowed to take any tax free cash.
The tax free cash figure from each scheme will be calculated at the time you are due to take those benefits. This triggers a BCE, which requires a check against your lifetime allowance. Any previous benefits taken will count against the amount of lifetime allowance you have left available, and you will be entitled to take up to 25% of that reduced figure as tax free cash.
Protection of tax free rights
Prior to A-Day, the rules of some occupational pension schemes allowed members a cash lump sum greater than 25%. For benefits earned before 6th April 2006, members will automatically retain these rights for the higher lump sum figure without attracting any lifetime allowance charge (that is – without being taxed on the amount over 25%). However, these rights are lost when a member transfers his benefits to another scheme (unless it is part of a ‘block transfer’). For any benefits earned after 6th April 2006, the 25% tax free limit will apply to that portion of your benefits.
Retirement Age
The normal minimum pension age from a registered pension scheme is age 50 for retirements up to 5th April 2010. From 6th April 2010, this rises to age 55.
But remember that the age when you can draw your pension benefit depends upon the Rules of your pension scheme, which may set its minimum age higher than this.
From 6th April 2010 the only persons allowed to take pension benefits before age 55 will be:
- People who retire early due to ill-health or serious ill-health
- Members who have a contractual right as at 9th December 2003 to take benefits from age 50
- People who were members of their pension scheme before 6th April 2006 who had a right (a professional footballer, for example) to take their pension benefits earlier than age 50.
If this applies to you, then you must protect this right after 6th April 2006 by contacting the administrators of your scheme. There will be a 2.5% deduction to the lifetime allowance for each year benefits are taken before age 55. So, if this applies to you, and you want to retire at say, 50 and you wish to retain this right after 2010, your lifetime allowance will be 12.5% less than would apply to someone retiring at age 55.
Flexible Retirement
There can be greater flexibility about taking your benefits and continuing to work with the same employer that sponsors your occupational pension scheme.
Before 6th April 2006, you could not access benefits from an occupational scheme without leaving the employment to which the benefit related – unless you transferred those benefits to an alternative arrangement. This is no longer necessary Employees can continue to work for their employer whilst drawing their pension benefits provided the occupational scheme rules permit.
You may, for example, wish to work part-time and access part of your pension fund in order to augment your salary. That will be allowed if your employer offers this facility.
You may draw your benefits at any age between 50 (55 from 6th April 2010) and 75, subject to the scheme rules permitting it. At age 75 there are specific rules on how you may secure your benefits.
Ways to Take your Pension Benefits
The pension benefits available to you will depend upon the options defined in the Scheme Rules.
As your benefits are held in a defined contribution scheme, you will receive your annual pension either directly or indirectly from the scheme. You may also receive a tax free cash lump sum.
For money purchase arrangements, there will be four possible ways to create the pension that suits your requirements:
- Secured Income. This is where the pension fund is used to buy an annuity from an insurance company. This provides an income for the rest of your life, which may also include a pension to be paid to a spouse, civil partner or dependant on your death.
- Scheme Pension. Some very large pension schemes will offer an income paid directly from the scheme based upon your fund value.
- Unsecured Income (previously known as Income Drawdown) - instead of having to buy an annuity, you can choose to take your tax free lump sum and leave the remaining fund invested, drawing income from this fund when required. There is no minimum annual withdrawal, so if you do not need the income in any given year, you can suspend payments. The maximum income is calculated from a set of annuity tables produced the Government Actuary’s Department. This option will be available only until age 75.
- Alternatively Secured Pension* (ASP). All pension benefits have to commence by age 75. However, on reaching 75, if you do not want to purchase an annuity, benefits can be in the form of "alternatively secured pension" where you may take an income from the fund (up to a maximum per year). On your death, there can be no lump sum paid. The remaining benefit must be paid to your dependants as income (pension). If you have no dependants, you may nominate either another member of your scheme to receive the income, or a registered charity.
The ASP method has caused much controversy with HMRC keeping a watchful eye on how these are being marketed. It is essential that you seek advice from an experienced financial adviser conversant with ASPs, if you wish to consider this alternative.
Most schemes will only offer the first two options (and, more likely, the first only). The other options are more likely if you transfer these funds into specialist financial products for which you will need the corresponding professional advice.
Trivial Pensions
Where the value of your total pension benefits are not more than 1% of the lifetime allowance, these benefits can be taken wholly as a lump sum. For the year 2007/2008 therefore, 1% of £1.6 million is £16,000.
The new rules will allow more people to take the whole of their benefit as a lump sum. This will assist members with small benefits because the cost of buying a pension annuity is often disproportionate to the value of the fund.
Where you are able to take your pension on the grounds of ‘triviality’, 25% of the fund can be taken as tax free cash, with the balance of the lump sum being taxed as earned income at your normal tax rate.
All your pension benefits that make up this total must be commuted within a twelve month period, which can be at any time between your 60th and 75th birthday. You can include pensions already in payment within the calculation (but these will be taxed at your normal rate and may not be taken as tax free cash). This requirement demands a high level of cooperation and coordination to succeed when there are a number of arrangements involved. The HMRC, in trying to avoid abuses, have made the option impractical in many situations. There is pressure to relax this rule.
You may continue to contribute to other pension funds after commutation has completed.
Death Benefits
There are now a total of 9 different types of lump sum death benefit and 4 different types of dependants’ benefits. The benefits payable will depend upon factors such as the type of scheme you are in; whether you have begun to draw your benefits; and your age at the date of your death (with age 75 being particularly import to some of these categories).
Death before retirement
If death occurs before retirement all death benefits may be paid in the form of dependants’ pension (where scheme rules allow). Any pension will be subject to tax at the dependant's normal tax rate. Dependants’ pensions are not tested against the member’s or dependants’ lifetime allowance.
There is no limit on the amount of lump sum death benefit payable. Any lump sum must be paid within two years of the death of the member. Lump sum death benefits will be tested against the member’s lifetime allowance.
For money purchase arrangements, (such as AVCs and FSAVCs) if the member dies before retirement, any lump sum death benefit is subject to the lifetime allowance.
Death after retirement
On death after retirement, any payment ‘guarantee period’ for the member’s pension will still apply (if applicable), the member’s pension will therefore continue to be paid to the beneficiary or estate until the end of the ‘guarantee period’ on the deceased members pension.
In addition, if the scheme rules permit, dependants’ pensions can be paid, and any other lump sum death benefit can be paid if the member dies before age 75. Lump sum death benefits will not be tested against the member’s lifetime allowance, but may be subject to a tax charge (of 35%).
More restrictive rules apply after the age of 75.
Death benefits that exceed the Lifetime Allowance
Whilst most people’s benefits won’t get close to the lifetime allowance, for those whose total pension benefit value might exceed that limit, it is worth considering the tax charges that applies.
If the death benefit makes the deceased person’s total benefit exceed the lifetime allowance, then tax charges would apply to the amount that exceeds the allowance:
- If the excess over the lifetime allowance is payable as a lump sum to the beneficiaries, the excess will be subject to the 55% lifetime allowance charge.
- If the excess over the lifetime allowance is used to pay a dependants’ pension, it will not be subject to the lifetime allowance charge. Dependants would pay tax on dependants’ pensions at their normal tax rate.
If death occurs after retirement, the taxation treatment of death benefits will depend upon the form of the benefits the member chooses at retirement date.
Summary & Key Points
When making enquiries about your pension benefit it is very important that you make it clear whether you are an active member, a preserved member or a pensioner member. Active, preserved and pensioner are different classes of membership of a pension scheme and any definitions and paragraphs contained within your Scheme Rules or scheme literature relating to any benefit may differ considerably between these categories.
On average, people change jobs every 5 to 6 years. It is possible therefore, that you will have more than one pension benefit. For each pension benefit you need to consider the following items:
- Keep informed. Because of A-DAY, your scheme may modify benefits and Rules. Legislation may change. Your circumstances may alter.
- Rules differ from scheme to scheme and are wide and varied in content. Don’t assume that what applies to one of your pension schemes will necessarily apply to others that you may have.
- HMRC (HM Revenue and Customs) impose rules that registered pension schemes must conform to.
- People seldom have identical pensions and you should avoid drawing comparisons with colleagues whose circumstances may at first appear the same but could emerge as having significant differences.
This is not an authoritative document. Seek professional advice from an appropriately experienced and qualified adviser.
Useful Links to Websites or Documents with related articles
A-Day: Changes in detail DC Schemes v1.6 Generic
Last update 01/10/2007
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