Tech talk

Annual Allowance - TT23/06

The annual allowance is one of the ways that the Revenue restricts the tax privileges on pension savings. An annual allowance income tax charge of 40% of the value of the pension savings in excess of the annual allowance is payable by the scheme member.

The annual allowance is separate from the ability to obtain tax relief on pension contributions. It is important to recognize the two as being separate, independent processes.

The annual allowance for the first 5 tax years of pension simplification is detailed in the following table.

Table 1

Tax Year	Annual Allowance
2006/07	£215,000
2007/08	£225,000
2008/09	£235,000
2009/10	£245,000
2010/11	£255,000

 

Valuing Pension Savings

For the purposes of valuing pension savings it is necessary to determine

• the pension input period, i.e. the period (normally 12 months) over which the contributions are paid or the pension benefits accrue, and
• the pension input amount, i.e. the total of the relevant contributions paid and/or the pension benefits that have accrued during the pension input period

In a money purchase scheme the pension input amount is the total of all tax relievable contributions paid by or on behalf of the member plus any contributions paid by his/her employer.

In a defined benefit scheme it is necessary to use a notional value. The notional value is calculated by multiplying the increase in pension savings by 10. If the pension commencement lump sum (tax free cash) is provided as a separate benefit, rather than by commutation, then this should also be added. The following example should help illustrate how valuations are determined

Example 1

A member of the NHS pension scheme has pensionable earnings of £40,000 and has 20 years service at the start of the year. Pensionable earnings and salary have increased to £44,000 at the end of the year.

In addition to the 6% contribution rate, £200.00 (gross) per month is being paid into a money purchase AVC.

Calculation:

AVC £200.00 x 12……………………………………£ 2,400.00
Scheme pension [(21/80 x £44,000) - (20/80 x £40,000)] x 10…………....£15,000.00
Scheme cash (21 x 3/80 x £44,000) - (20 x 3/80 x £40,000)………………£ 4,650.00
Total…………………..£22,050.00

In Example 1, the 6% contribution that the member is required to make to the scheme is ignored because it is the increase in benefit that is valued, whereas the AVC scheme contribution is taken into account because it is providing money purchase benefits.

Valuation Period

It will not be practical for pension schemes to value the pension savings over the period of a tax year as most pension schemes and arrangements will not have anniversaries that coincide with the tax year. Therefore to determine what pension savings relate to a tax year, it is the pension input period that ends in the tax year that is used. Where a client has a number of different pension schemes and/or arrangements each will have its own pension input period. The following example may help:

Example 2

Client is a member of 2 schemes. In one of the schemes there are 2 arrangements. Scheme A has a pension input period beginning on 30th March. Scheme B, arrangement 1 has a pension input period beginning on 30 September. Scheme B, arrangement 2 has a pension input period beginning on 31st December.

For the tax year ending 5th April 2009, the pension input periods to be used are:

Scheme A…………………………..30th March 2008 to 29th March 2009
Scheme B, arrangement 1…..……...30th September 2007 to 29th September 2008
Scheme B, arrangement 2………….31st December 2007 to 30th December 2008

It is possible to change the pension input period. Who is allowed to change the pension input period is determined by the nature of the pension scheme. In addition there are restrictions as to the dates that the pension input period can be changed to for all pension input periods except the first, where the only restriction is that it cannot be longer than 1 year.

Who can change the pension input period?

In a defined benefit scheme only the scheme administrator can change the pension input period. For money purchase schemes the scheme administrator and the scheme member can change the pension input period. Where both the scheme administrator and scheme member notify a change it will be the first notification that will have priority.

What date can the pension input period be changed to?

The start of the first pension input period will commence when either the first contribution is paid to a money purchase arrangement or when benefits first accrue in a defined benefit arrangement. When the pension savings commenced prior to 6th April 2006, the first pension input period will commence when the first contribution is paid or benefit first accrues after 'A-day'. The end date of the first pension input period will default to 12 months after the start of the pension input period. The start of the second and subsequent pension input periods will commence immediately following the end of the previous pension input period. The end of the second and subsequent pension input periods will default to 12 months from the end of the previous pension input period. The end date of the second and subsequent pension input periods can be changed to an earlier date provided that earlier date falls in the same tax year as the default date.

The following example may help:

Example 3

New money purchase arrangement taken out 1st October 2006.

Option 1. No notification made in respect of the first pension input period.

The first pension input period will be 1st October 2006 to 30th September 2007. As the pension input period falls in the 2007/08 tax year the first contribution will be assessed against the 2007/08 annual allowance of £225,000. If a second contribution is paid on 1st October 2007 then this must be assessed against the 2008/09 annual allowance of £235,000. Even if a notification is made in respect of this second contribution the rules restrict the end date so that it still ends in the 2008/09 tax year, therefore the new end date must fall in the period 6th April 2008 to 30th September 2008.

Option 2. Notification is made in respect of the first pension input period.

The first pension input period will start on 1st October 2006 but can end in the period 2nd October 2006 to 30th September 2007. Therefore the end date will either fall in the 2006/07 or 2007/08 tax year depending on the end date. If a second contribution is paid on 1st October 2007 then this will be assessed for annual allowance purposes in the tax year that includes the date 12 months from the end date of the first pension input period. So if the first pension input period ends on 31st December 2006, the second pension input period ends on 31st December 2007 and this can be changed to a date within the range 6th April 2007 to 30th December 2007.

Exemption from Annual Allowance

There is no test against the annual allowance in any tax year throughout which enhanced protection applies in respect of the member. That apart, there are two events where the annual allowance assessment does not apply in the tax year. One is death and the other is taking all of the benefits from the arrangement. If a client has more than one arrangement the exemption only applies to the arrangement(s) from which all of the benefits have been taken. Where all of the benefits are taken from an arrangement the pension input period in respect of that arrangement ends on the date on which benefits are taken.

Example 4

A contribution of £300,000 is paid on 1st October 2006. This is the first post 'A-day' contribution and no nomination has been made regarding the end of the pension input period which therefore ends on 30th September 2007. A further contribution of £500,000 is paid on 1st October 2007. The client takes all benefits from the scheme on 31st December 2007.

2006/07
There is no annual allowance charge as there is no pension input period ending in this tax year.

2007/08
There is no assessment to the annual allowance as all of the benefits have been vested.

2008/09
There is no annual allowance charge as the pension input period which was due to end on 30th September 2008 came to an end when the benefits were taken on 31st December 2007, i.e. in the 2007/08 tax year.

Paying the Annual Allowance Charge

The tax has to be paid by the scheme member, and it is his/her responsibility to notify the Revenue using the self assessment tax return. If the scheme member does not usually receive a tax return then he/she should request one from the Revenue. Failure to do so will result in the usual income tax penalties.

Tax Relief on Member Contributions

The connection between the annual allowance and a member's personal contribution is that it is only tax relievable contributions that count towards the annual allowance. Personal contributions that do not qualify for tax relief are not included in the pensions savings for annual allowance purposes.

With the loss of carry back for personal contributions, tax relief is only available in the tax year that the contributions are actually paid. The following example may help:

Example 5

Client earns £400,000 in 2006/07 tax year, and pays £400,000 into a pension scheme on 1st March 2007. The pension input period runs from 1st March 2007 to 29th February 2008. Tax relief will be obtained in the 2006/07 tax year.= The annual allowance will be assessed in the 2007/08 tax year. The annual allowance is £225,000 and therefore the annual allowance charge will be £70,000.

There is a way to avoid the annual allowance charge in Example 5 without having to take all the benefits. The client can split the contribution and pay £215,000 on 1st March 2007, then nominate 2nd March as the end date for the first pension input period. The client then pays the remaining £185,000 on 3rd March 2007. In doing this, the £215,000 will be assessed in the 2006/07 tax year when the annual allowance is £215,000 and the £185,000 in the 2007/08 tax year when the annual allowance is £225,000. Splitting the contribution this way does not alter the fact that the tax relief for the pension contribution will be obtained in the 2006/07 tax year.

Tax relief for employer contributions is given against the profits in the trading year that they were paid in, provided they are allowed to be deducted as an expense in computing profits of the trade, profession or investment business, thereby reducing the employer's taxable profit. Whether or not tax relief is granted, employer contributions are taken into account for annual allowance purposes.

One of the attractions of investing in a pension is the tax relief on the contribution. The operation of the annual allowance is to limit the tax privileges available on pension savings. Hence the reason that the only personal contributions that are included in the annual allowance assessment are those that qualify for tax relief. Tax relief on personal contributions is limited to 100% of salary whereas tax relief on employer contributions is at the discretion of the local inspector of taxes. Hopefully the above demonstrates that tax relief on contributions and the annual allowance are two separate functions within pensions simplification.

Fraser Grant - June 2006