Guide to Pension rules
The UK government introduced a raft of new pension rules, effective from 6 April 2006, which are known as ‘pension simplification’ and are designed to make saving for more easy and taking benefits more flexible.
Simplification entailed lifting many of the petty-fogging rules surrounding contribution limits and the distinctions between company and personal pensions.
This allows individuals to view their pension arrangements more holistically, as the pension contribution limits are now applicable across all types of pension scheme. The same applies to the ‘lifetime allowance’ (£1.5m in 2006-07, £1.6m in 2007-08) which limits the amount you can hold in aggregate in all your pension schemes and still enjoy the various pension tax reliefs.
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Why would anyone want to invest in a pension, after so many scandals and bad publicity about them? Well, the answer is quite simply tax relief.
All allowable contributions to pension plans enjoy tax relief at your marginal rate of tax. This means that a basic rate tax payer who wants to contribute £1,000 into a personal pension will only have to actually invest £780 because the tax relief is £220. Higher rate tax payers can claim a further 18 per cent tax relief through their self assessment.
This means that for a higher rate taxpayer a £1,000 contribution costs only £600 after tax relief.
If you are making personal contributions, you automatically pay the contribution net of standard rate tax relief (even if you are a non taxpayer) and your pension provider will recover the 22 per cent tax relief and add it to your fund.
However all employer contributions are paid gross and your employer will claim tax relief through the pension provider on your behalf. Back to top
The main points are.
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- the maximum annual contribution you can make is 100 per cent of your earnings up to a maximum of £ 215,000 for the tax year 2006-07.
- only pension funds below the lifetime allowance (£1.5m in 2006-07) will benefit from tax relief.
Your employer can make contributions into your personal pension, but the total of all employer and personal contributions must not exceed the annual limit of £215,000 (for 2006-07) Back to top
Since April 2006, the restricted list of permitted investments has been replaced and now any investment that is deemed to be a commercial investment will be allowed. This means that income drawdown plans (now known as Unsecured Pensions) will be allowed to invest in most assets including the following:
- stocks and shares listed or dealt on an Inland Revenue recognised stock exchange, including AIM;
- stock exchanges that are not recognised by HMRC, such as Ofex;
- unit trusts, open ended investment companies (OEICs);
- warrants, covered warrants;
- government stock and fixed interest stock;
- unquoted shares;
- commercial property
- collective property funds
Initially, the Government was going to allow personal pension funds to invest in residential property and this created considerable interest from investors. However in December 2005, the Chancellor announced a U-turn by announcing that additional tax would be charged if a pension fund invested in residential property.
If a Sipp invests in residential property or 'prohibited investments' such as vintage cars, works of art or fine wines, an extra charge of up to 70 per cent of the value of the prohibited investment will be applied.
This means that although it will be possible to invest in residential property, the additional tax charge makes it an unattractive option. Back to top
There will a tax charge (called an unauthorised payment charge) of 40 per cent on any non-commercial use of an asset. Wasting assets (such as wines, cars, yatchs) will incur an extra tax charge (scheme sanction charge) of 15 per cent, if the investor uses this asset for his personal enjoyment. Back to top
You can borrow up to 50 per cent of the value of your Sipp for property purchase, but Sipps cannot make loans to you for your personal use.
The 'connected party' rule for commercial property purchase no longer applies which means you can purchase your own commercial premises and rent them back to your own business, while paying the rental gross into your individual or group Sipp.
In order to achieve the maximum investment flexibility, many income drawdown policies are set up as Sipps. Back to top
Since A-Day, 6 April 2006, when the new rules for pensions simplification came into effect, there has been greater choice and flexibility in the way you can arrange your retirement income. Back to top
The first bit of good news is that some people may get more tax free cash than they would have been entitled to before A Day. Since A-Day, all pension schemes including top up pension plans such as AVCs (additional voluntary contributions) and FSAVCs, can pay up to 25 per cent of the fund as a tax free cash sum.
If you were entitled to more than 25 per cent cash from your scheme prior to A Day, you may still be entitled to this. Back to top
There is a new annuity option called 'value protection' which is better known as the 'money back' option. This means that if you die before the total payments you have received are at least equal to the original purchase price, you will get the difference back.
For example, if you bought an annuity with £50,000 (the 'purchase price') and died after only receiving £30,000 worth of annuity payments, the difference of £20,000, less a tax charge of 35 per cent, would be paid to your estate. This means the payout to your dependant/s would be £13,000.
However, value protection is only available until age 75. If you want to protect your annuity income after that age, you would need to buy a 10 year guarantee after age 65. Back to Top
If you have a very small fund/s, pension simplification allows you to take the entire fund as cash. If the value of all your small pensions funds is less than £15,000 (in tax year 2006-o7), they will be classed as trivial and you will be able to take the whole lot as cash.
A quarter of the fund/s can be taken tax free, but you will pay income tax on the remainder. You must take into account all your pension funds, including the value of any pensions you are already receiving, when assessing whether your total funds fall within the £15,000 limit. You must also take all such trivial funds within one 12 month period.
The trivial fund limit will rise each year, as it is based on 1 per cent of the lifetime allowance, so in 2007-08 it will be 1 per cent of £1.6m, or £16,000. Back to top
Since A-Day, the term income drawdown has changed to Unsecured Pension (or Unsecured Income).
The major change is that the maximum income you can take has increased to roughly 120 per cent what a single life annuity (calculated by the Government Actuaries Department (GAD), would pay for someone of your age.
There is no minimum income as you are not obliged to take an income each year. In fact, you can take zero income and leave your entire fund invested until age 75, if you so wish.
To make sure that your income limits are linked to current annuity rates, your Unsecured Income will be formally reviewed every 5 years instead of every 3 years, as was the case pre A-Day.
If you die before age 75 while taking an Unsecured Income, the remaining fund can be paid to your dependants less 35 per cent tax, a spouse could continue taking a Unsecured Income or it can be used to provide an income via an annuity. Back to top
Since A-Day, the compulsion to buy an annuity at age 75 has been removed and now you are allowed to continue with a limited type of drawdown for the rest of your life if you so wish. This new option is called taking an ‘Alternatively Secured Pension’ or (ASP).
ASP will allow you to draw a maximum income of 90 per cent of the single life annuity for someone aged 75. Unlike Unsecured Income there will be a minimum income that you must take, which is 65 per cent of the rate for a 75 year old (even if you are older than age 75).
For many, the attraction of ASP is the potential to leave funds to your family on your death. Originally, this was going to possible because the rules allowed for any remaining funds to be used to supplement the pensions of other scheme members and the so-called family Sipp concept was developed.
However, this option was removed in December 2006 and it is not possible to transfer funds to family members if there are no dependants, without paying a large amount of tax. Any such payment will be treated as an authorised payment and taxed at up to 82 per cent.
That said, if you have a £1m fund when you die, being able to bequeath £180,000 to your heirs is better than not being able to leave them any funds at all (which was the case prior to A-Day due to obligatory annuity purchase at age 75). Back to top
How do the new rules affect decisions at retirement? The vast majority of people will still buy annuities because they are the only instrument that will guarantee a high level of income and security in retirement.
Drawdown may seem attractive, but many people grossly underestimate the risks and are attracted to the death benefits when they should really be concentrating on maximising their income.
That said, you do not have to put all of your eggs in one basket and you can consider purchasing more than one type of annuity - for example a level annuity and a with-profits annuity.
The latter pays an income that will increase or decrease in future years, depending on investment returns. The A-Day rules also allow you to retire gradually. For instance, can take your tax free cash, but defer taking a pension.
Used wisely, the greater flexibility now available should enable you to plan for a better retirement, but to get the most from the new rules you will need specialist independent financial advice.
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||What’s on offer |
|value protection option
||on death the difference between capital invested and payments received can be paid, less 35 per cent tax |
|tax free cash
||now called "pension commencement lump sum." 25 per cent of the fund, but there is protection for higher percentages built up prior to A-Day. |
||can be taken as cash, providing the total value of your pensions do not exceed £15,000 (up to April 2007), £16,000 (in 2007-08). |
||Income limits range from £0 – 120 per cent of roughly what a single life, level annuity would pay someone of your age (120 per cent of 'GAD' rates |
||no changes to death benefits. |
|limited period annuities
||limited period annuities (usually up to five years) available |
|Alternatively secured pension
||maximum income 90 per cent of GAD rates at age 75 and the minimum income 65 per cent |
||on death, fund must provide a dependant's pension. If no dependants, fund may be paid to charity. |
||If funds paid to anybody who is not a dependant, there is a tax charge of up to 82 per cent |