Guide to pension rules

Pensions may be desperately dull but there’s no escaping the need to save huge sums for retirement.

If you bear in mind that a £100,000 fund will buy you an income of around £5,000 a year, you start to realise just how important it is to start saving early, if you are to have a hope in hell of achieving a fund of, say, £500,000, which might  buy you a pension of around £25,000 a year.

So what’s new?

Since April 2006, it has been possible to contribute up to 100 per cent of your earned income each year, with tax relief to the extent that you have paid tax on earned income. So if you earn £50,000 you could invest the whole lot in your pension with tax relief, but not more than that.

You can also contribute to as many different pension schemes as you like, so you can contribute to a personal pension, as well as a company scheme at the same time. Very large contributions are also allowed in the year you retire.

There is also more flexibility as to how, and when, you can take your pension, including money back annuities and the open market option – which allows you to shop around for the best annuity rate rather than accept the offer from your existing pension provider.

Tax relief

Why would anyone want to invest in a pension, after so many scandals and bad publicity in recent years? Well, the answer is quite simply tax relief.

Contributions to all types of pension scheme automatically attract basic rate tax relief at 20 per cent. This means that you only have to write a cheque for £800 to make a gross contribution of £1,000, with the taxman topping up your pension with £200.

Even non taxpayers can contribute up to £2,880 net (£3,600 gross) into a stakeholder pension and benefit from basic rate tax relief at 20 per cent.

For a higher rate taxpayer, a £1,000 contribution costs only £800 upfront, and a further £200 tax relief can be claimed via one’s self assessment tax return, bring the net cost down to £600.

Rules have recently changed for those earning over £130,000pa See Here For Information About These New Rules.

With company-sponsored final salary schemes, tax relief is claimed by your employer.

If you invest in a group personal pension, your contributions will be paid net of basic rate tax, but if you are a higher rate taxpayer, it is up to you to reclaim the extra 20 per cent tax relief via your tax return.

This is because, although your employer sets up a group personal pension scheme for the benefit of the workforce at the outset, the pension plan is actually a contract between you and the insurance company, just like any other personal pension, so it is up to you to remember to reclaim higher rate relief.

In tax year 2010-11, higher rate tax kicks in at £37,401

How much can I contribute?

The maximum annual contribution is 100 per cent of your earned income up to a maximum of £ 255,000 in tax year 2010-11.

The lifetime allowance – the maximum pension fund size you can have while enjoying tax privileges is  £1.8m in tax year 2010-11.

Employer contributions

Your employer can make very large contributions into your personal pension, provided that the total of all employer and your personal contributions does not exceed the annual contribution limit of £255,000 (for 2010-11).

Permitted investments

It is now possible to invest in a very wide range of investments via a Self Invested Personal Pension or Sipp including:

Stocks and shares listed or dealt on an HMRC recognised stock exchange, including AIM.

Stock exchanges that are not recognised by HMRC

Unit trusts, open ended investment companies (OEICs);

Warrants and covered warrants;

Government stock and fixed interest stock;  

Permanent interest bearing shares (PIBs)

Commercial property;

Hedge funds

Private equity

Collective property funds

This is not a comprehensive list but gives you an indication of the wide investment freedom you now have.

You cannot invest in residential property or 'prohibited investments' such as vintage cars, works of art or fine wines within a Sipp, as originally proposed.

If you do invest in these assets an extra charge of up to 70 per cent of the value of the prohibited investment will be applied.

This means that although it is possible to invest in residential property and exotic investments, the additional tax charge makes this an unattractive option.

Non-commercial use of assets

There is 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, yachts) incur an extra tax charge (scheme sanction charge) of 15 per cent, if you use an asset for your personal enjoyment which is why these investments are effectively no longer viable investments.

Borrowing for commercial property purchase

If you have a Sipp. you can borrow up to 50 per cent of the net value of the Sipp for commercial property purchase, but Sipps cannot make loans to you for 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 yourself, while paying the rental gross into your individual or group Sipp.

Annuities and drawdown since 6 April 2006 (A-Day)

Since 6 April 2006, there has been greater choice and flexibility in the way you can take your retirement income. You can do income drawdown until age 75 via an Unsecured Pension and after age 75 via an Alternatively Secured Pension. (For more on these read our Guide to drawdown).

Annuities have become more flexible with ‘money back’ annuities now available. These give you back most of your unused pension fund if you die before age 75.

The rules governing final salary schemes have been relaxed so that you can draw a company pension, while working for the same employer.

There also some new hybrid products which are a mixture of annuities and income drawdown (see Guide to your options at Retirement).

Tax free cash

Some people may be entitled to  more tax free cash than they would have been entitled to before 6 April 2006 (known as A Day), when sweeping new pension rules came into force.

Since that date, all pension schemes, including top-up pension plans such as AVC plans (additional voluntary contributions) and FSAVCs, can pay up to 25 per cent of the pension fund as tax free cash.

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 (but you should take advice on protecting your position, if you have not already done so).

Money back annuities

There is a new annuity option called 'value protection' or 'money back' annuities.

If you die before age 75, a money back annuity will pay to your estate a lump sum equal to the purchase price, less annuity payments made to the date of death, and less a 35 per cent tax deduction.

For example, if you bought an annuity with £50,000 (the 'purchase price') and died after having received £30,000 in annuity payments, the difference of £20,000, less a tax charge of 35 per cent, would be paid to your estate, so the payout would be £13,000.

However, because 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.

Trivial funds

If you have a very small fund/s, the new rules allow you to take the entire fund as cash. If the value of all your small pensions funds is less than £16,500 (in tax year 2008-09), they will be classed as trivial and you will be able to take the whole lot as cash.

A quarter of this lump can be taken tax free, with the balance being taxable.

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 £16,500 limit. You must also take all such trivial funds within a 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 2010-11, it will be 1 per cent of £1.8m, or £18,000.

The April 2008 budget introduced a proposal that there should be an additional trivial pension limit just for occupational pension schemes of £2,000.  

But at the time of writing, this had not been enacted.

Income DRAWDOWN

You can defer annuity purchase when you retire, by keeping your pension fund invested in an ‘Unsecured Pension.’

This allows you to take up to 25 per cent of the fund tax free and an income each year, if you so wish, although there is no obligation to take any income at all.

The maximum income you can take is roughly 120 per cent what a single life annuity, (as calculated by the Government Actuaries Department (GAD)), would pay for someone of your age.

There is no minimum income as there is no obligation to take an income. In fact, you can take zero income and leave your entire fund invested until age 75..

To make sure that your income limits are linked to current annuity rates, your Unsecured Pension must be formally reviewed every 5 years.

If you die before age 75 while taking an Unsecured Income, there are three options:

the remaining fund can be paid to your dependants less 35 per cent tax;

a spouse could continue taking an Unsecured Income; or

the fund can be converted into an annuity.

Alternative secured pension

When you reach age 75, you are allowed to continue taking a restricted form of income drawdown for the rest of your life, called an ‘Alternatively Secured Pension’ or (ASP).

ASP allows you to draw a maximum income which is roughly equivalent to 90 per cent of a single life annuity for someone aged 75.

The minimum income you can take is 55 per cent of a standard annuity for a 75 year old. These income limits remain tied to annuity rates for a 75 year old, so they do not rise with age.

It is not possible to transfer funds to family members if there are no dependants, without paying a large amount of tax. Any such payments will be treated as an ‘unauthorised payment’ and taxed at up to 82 per cent.

For instance, if you have a £1m fund when you die, you could bequeath 18 per cent of it free of tax, or £180,000, to your heirs.

Alternatively, the fund can be used to pay a pension (but not a cash lump sum) to a spouse or civil registered partner.

If you have no dependants, you can donate the remainder of your fund to charity, free of tax.