You will be aware from our last Newsletter that the new legislation which is effective from 6 April 2011 brings in new rules for drawdown cases. GAD rates are changing and the maximum pension is going to be 100% of GAD rather than 120% of GAD. Any review that is due now will be held for the next 5 years, unless the client wishes a review to be completed earlier. Though very few clients take 120% of GAD if your client has a Pension Commencement Date anniversary falling between now and 5 April 2011 then they can request that the review is done now early and the new figures would hold for the next 5 years or age 75 if earlier.
The proposals to change the way we take benefits from money purchase schemes (including personal pension schemes) were more radical than many expected. The rules appear to be simpler than what went before and certainly more flexible for those with significant pension funds.
The lifetime allowance
The government’s proposals make changes to the lifetime allowance. From the tax year 2012/13, the lifetime allowance will reduce from £1.8 million to £1.5 million. The lifetime allowance tax charges remain at 55% and 25%.
For individuals who run the risk of breaching the revised allowance there is an option to claim ‘fixed protection’ by 5 April 2012. HMRC will provide forms. Fixed protection freezes the lifetime allowance at £1.8 million, but subject to conditions that are similar (but not the same) to those that apply to a claim for enhanced protection. Fixed protection will be lost if, after 5 April 2012:
- there is further benefit accrual such as payment of contributions;
- the member takes out a new arrangement other than to accept a transfer of pension rights;
- there are certain ‘impermissible’ transfers or transfers that are ‘not permitted’.
Fixed protection is not available to individuals who have claimed enhanced or primary protection, but neither is it needed because these options are not affected by the reduction in the lifetime allowance: protected benefits are not reduced with the lifetime allowance.
Dealing with the consequences
Equally important to the reduction in the lifetime allowance are the consequences for a number of rules that are associated with it.
For example, the trivial commutation and winding-up lump sums have been limited to one per cent of the lifetime allowance and are currently limited to £18,000. From 6 April 2012, the limit becomes £18,000 and The Treasury is given power to increase the figure. The age limit for paying a range of lump sums including a defined benefit lump sum (life assurance) is removed.
Retirement lump sum
More important is the impact on the pension commencement lump sum. If fixed protection is not claimed, then the overriding maximum lump sum will reduce to 25% of the lower lifetime allowance: £375,000.
If the member has claimed primary or enhanced protection and the lump sum entitlement at 5 April 2006 stood at £375,000 or more (member-level protection) the reduction in the lifetime allowance will have no effect on the protected lump sum. The lifetime allowance will be assumed to have remained at £1.8 million or the current standard lifetime allowance if that is higher in future. There is no need to claim fixed protection.
If the member has scheme specific lump sum protection because the scheme does not fall within the previous category, but the lump sum exceeds 25% of pre-2006 rights, then the protection will continue on the basis that the lifetime allowance is £1.8 million or a future higher standard lifetime allowance.
Value of arrangement on 6 April 2006 £200,000
Value of pre-2006 lump sum rights at 6 April 2006 £100,000
Lifetime allowance in 2006/07 £1.5 million
Lifetime allowance in 2011/12 £1.5 million
‘Protected’ lifetime allowance £1.8 million
Value of lump sum rights in 2011/12 £120,000
The Requirement to Annuitise
The headline changes concern what HM Treasury calls ‘The Removal of the Effective Requirement to Annuitise by Age 75’. The central features are the abolition of the alternatively secured pension for new and existing arrangements and the reduced significance of age 75 in retirement planning. The measures are effective from 6 April 2011.
Change to Benefit Crystallisation Events (BCEs)
BCE 5A is currently described as reaching age 75 whilst in receipt of an unsecured pension. For the purposes of measuring against the lifetime allowance, the value is taken as the value of the fund less the aggregate amount of funds already crystallised under BCE 1 (designation of USP). Under the new rules, the BCE refers to the member reaching age 75 whilst a member of a money purchase scheme. The value is the aggregate of the fund supporting drawdown (if any) and ‘unused’ funds.
Abolition of Alternatively Secured Pension (ASP)
Under current rules, the fund converts to ASP at age 75. The new rules will abolish ASP and rename Unsecured Pension (USP) as ‘drawdown pension’. Drawdown pension will continue up to and beyond age 75 until the member dies or chooses to convert the fund to a scheme pension or annuity. When the member reaches that age BCE 5A will measure benefits against the lifetime allowance and there will be no further BCE.
Short-term annuities will not be required to expire by age 75, but they will still be restricted to a five year term.
Drawdown pensions will offer two options.
This will be similar to the current unsecured pension. The withdrawal ‘limit’ will reduce to 100% of the basis amount (from 120% before 75) and the limit will have to be reviewed every three years until age 75 when reviews become annual. The option for member and administrator to agree an earlier review date remains.
The GAD rates will extend beyond age 75.
There is a technical amendment to prevent the value of drawdown funds reducing if there is an additional fund designation.
If an individual is in receipt of unsecured pension at 5 April 2011, the maximum withdrawal will remain at 120% of the basis amount until the earlier of the end of the five-year reference period and the end of the pension year in which there is a transfer to another arrangement or the member reaches age 75.
If the individual is taking ASP at 5 April 2011, the pension immediately converts to a drawdown pension and the maximum withdrawal becomes 100% of the (same) basis amount.
This will allow unlimited withdrawals providing that the individual has a ‘secure’ income that meets a ‘Minimum Income Requirement’ (MIR). The MIR may be provided by an annuity, a scheme pension or a state pension. Pensions from overseas will also qualify if they would be regarded as annuities or scheme pensions if they were established in the UK. The MIR will be set at £20,000 in 2011/12. This option will allow the whole of the fund to be withdrawn although given that it will be added to any other income for the year and will then form part of the estate, for tax purposes, this may be of doubtful use.
There will be no upper age limit for taking the pension commencement lump sum although the link with entitlement to an associated pension will continue for the time being (six months before the pension starts, twelve months after).
There are significant changes to death benefits. If a member dies while in receipt of a drawdown pension at any time, the tax charge on the drawdown pension lump sum will be 55% (previously 35% and only available below 75). However, there will be no liability to inheritance tax if the lump sum is subject to the discretionary disposal rules and this exemption will extend to the inherited liability where the lump sum payment is deferred to a dependant. Similar rules apply to the payment of an annuity or pension protection lump sum.
If the member dies before age 75 and leaves an uncrystallised lump sum the benefit will be tax-free. If the member dies after 75 and leaves an uncrystallised lump sum, the benefit will be subject to tax at a rate of 55%. It is simply impossible to have an uncrystallised fund after age 74 under the current rules so the issue of a tax charge did not arise.
The option to provide a tax-free charity lump sum death benefit is not only retained under the proposals, but is extended to deaths under the age of 75. This can be an important factor in estate planning (as well as being good news for charities).
The changes to retirement and death benefits are reflected in similar rules for dependants.
Serious ill-health lump sum
The new rules remove the age limit of 75 for claiming a serious ill-health lump sum (when expectation of life does not exceed 12 months). However although the lump sum remains tax-free under the age of 75, it becomes subject to tax at 55% from that age.
These are substantial changes that simplify the retirement rules for money purchase schemes and remove some of the tax penalties. One of the consequences is that some of the more expensive and in some cases more risky alternatives to SIPPs and SSAS (in particular, QROPS) become less attractive when compared with the proposed regime.
As things turned out, the government’s proposals for restricting tax on pension contributions were not as severe as we expected. They are certainly easier to understand than those proposed by its predecessor.
The annual allowance
The annual allowance is applied to registered pension scheme input for an input period. The relevant annual allowance is determined by the tax year in which the input period ends.
Under a money purchase scheme, the input is the contribution. Under a defined benefit scheme a factor is applied to the increase in benefit accrual over the period.
Input periods can be varied from time to time and can differ for different arrangements and different members.
The features of input periods are:
- They must not be longer than 12 months, but there is no minimum period (subject to below)
- For an arrangement there must be no more than one input period end in a tax year (although it is possible to have different input periods and input period ends for different arrangements)
- There cannot be a gap between one input period ending and another starting in respect of the same arrangement
The latest proposals for change are due to be implemented from 6 April 2011. This means that they will apply to any input period ending from that date so their impact will be felt before then.
The new rules in brief
The annual allowance tax charge will be the member’s marginal rate of tax after adding the excess contribution to the individual’s ‘reduced net income’ for the tax year in which the relevant input period ends. Until 5 April 2011, the rate is 40%.
The annual allowance will be £50,000. There is provision to increase this figure. Until 5 April 2011, the annual allowance is £255,000 and was frozen at that level. It had been trailed that it was going to be no more than £40,000.
In order to convert defined benefit accrual to input for these purposes, the increased accrual (after an inflation adjustment) will be multiplied by 16. Under the original rules the multiplier was 10, but we had been ‘primed’ to expect that this would change to between 15 and 20.
To recognise that earnings patterns can be irregular, any unused allowance (£50,000 less any allowance used in the year) may be carried forward for up to three years in order to supplement a later annual allowance. The main condition is that the individual must have been a member of a registered pension scheme in the year from which the unused allowance is to be carried forward even if their input amount was zero. In theory this allows a ‘one-off’ contribution of £200,000. There is no carry forward facility under the original rules (and no real need for one)
The allowance is unlimited in the tax year in which the member dies or becomes entitled to a serious ill-health lump sum under the arrangement. Until 5 April 2011the allowance was unlimited in the tax year in which all benefits were taken from an arrangement or the member died.
There are transitional provisions that deal with contributions made before 6 April 2011 and how to carry forward unused allowance from before that date.
The new rules cannot apply to an input period that ends before 6 April 2011. If the input period ends in the tax year 2011/12, then the annual allowance will be restricted to £50,000.
However, if the input period started before 14 October 2010 and ‘straddled’ that date and the following 5/6 April then the draft legislation requires that the input period be treated as if it ended on 13 October and a new input period started the next day.
This means that a contribution of up to £255,000 could have been paid before 14 October, but that any contribution paid after that date is restricted to the difference between £255,000 and what was actually paid, but subject to a maximum of £50,000.
For the purposes of determining how much unused allowance can be carried forward from 2008/09, the assumed allowance for each of those years is £50,000.
As with all these technical changes it is crucial to see the wood for the trees:
Remember that the anti-forestalling provisions of the special annual allowance apply until 5 April 2011.
Remember that the annual limit for relief on personal contributions (i.e. 100%/£3,600) is unchanged.
Remember that employer contributions are only deductible if wholly and exclusively incurred for the business. This may be relevant if unused allowance is being used.
The above is based on our understanding of the draft legislation announced in the Emergency budget on 14 October 2010.It should be noted this could be amended. DP Pensions Ltd do not accept any liability for the above information and would suggest that you seek legal advice before proceeding