Annual Pension Allowance Changes

Workers earning 150k+ face curbs to Annual Pension Allowance to fund Inheritance Tax Cut

Annual Pension Allowance Changes

Chancellor George Osborne will cut the amount higher earners are able to pay annually into their pension and still qualify for tax relief from April 2016.

The size of the annual allowance will be gradually reduced from £40,000 to £10,000 for those making between £150,000 and £210,000 a year, it was announced in the last Budget.

The Tories confirmed a manifesto pledge that the money this raises will be used to lift main family homes worth up to £1million out of inheritance tax if they are left to children or grandchildren.

The change follows an earlier announcement that the lifetime allowance – the total amount people can put in their pension pot during their lives and qualify for tax relief – would be cut from £1.25million to £1million from the 2016-17 tax year. It will be index-linked to inflation from 2018-19.

Tax relief is paid on contributions to pension pots in the form of rebates based on how much income tax you pay – 20 per cent, 40 per cent or 45 per cent. The system is aimed at encouraging people to save more for retirement, but at present you get a bigger tax sweetener the more you earn.

The Government currently pays out around £34.8billion a year in pension tax relief – including rebates to employers as well as workers.


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What do pension tax relief changes mean for you?

The general perception of reductions to lifetime and annual allowances is that only the wealthiest savers are hit. But opponents say reducing tax incentives to save for old age doesn’t only affect higher earners and is a bad idea in principle, because it effectively sets a limit on people’s ambition to get a decent pension.

To many, £40,000 might seem a very high sum to put in a pension in just one year, but people do sometimes come into large sums suddenly – from inheritances, redundancy payouts or property sales, for example.

Workers who feel they underfunded their pensions because they couldn’t afford the higher contributions in earlier life might well be keen to make up shortfalls if they become wealthier in later life.

Wage inflation means that if the lifetime allowance keeps being either frozen or cut, more middle-level earners will hit it too as time goes on. But if too many people are ensnared, future Governments will come under pressure to increase the allowance again.

The lifetime allowance also sounds like a lot of money – and it is – but see the box below for an example of how someone who starts out earning £30,000 could eventually run up against the £1.25million limit.

The current lifetime allowance system also benefits final salary scheme members more than defined contribution pension investors.

A pension pot of £1.25million will produce a very comfortable annual sum of around £62,500 if you are in a generous final salary scheme, which provides a guaranteed income for life.

It will buy just over £30,000 of guaranteed income from an annuity if you are in a far more stingy ‘defined contribution’ pension, which workers and employers put money into to build up a retirement pot.


What does the pension industry say?

David Smith, financial planning director at Tilney Bestinvest, said the reduction in pensions tax relief could lead to higher earners paying tax at an effective rate of 67.5 per cent.

‘The Institute for Fiscal Studies has identified that there are currently circa 300,000 individuals in the UK who receive taxable incomes that exceed £150,000 per annum, so this proposed change will only affect a relatively small proportion of the working population.

‘These individuals are already subject to income tax at 45 per cent on earnings that exceed £150,000 and, if you take into account National Insurance contributions of 2 per cent, they already only effectively receive 53p of every pound earned above £150,000.’

Jason Whyte, director in insurance at EY,said: ‘As expected, the Chancellor made changes to IHT [inheritance tax] and pensions tax relief that amount to “save less now, inherit more later


How annual allowance will be reduced if you earn £150,000 a year or more

Up to £150,000 £40,000
£160,000 £35,000
£170,000 £30,000
£180,000 £25,000
£190,000 £20,000
£200,000 £15,000
£210,000 £10,000

(Source: Retirement Advantage)

‘Today’s high earners won’t be able to save as much on a tax-free basis, but will be able to inherit the ancestral home and the remains of their parents’ pensions intact.

‘People might spend money that would have gone into their pensions on subsidising retired parents to preserve their pension pots. There’s also a big question about whether these changes, which bring tax revenue forward, will create a revenue hole for a later government.’

Ian Naismith, pensions expert at Scottish Widows, said: ‘We recognise that the Government needs to make savings and has identified pensions tax relief as one area where this is possible.

‘However, constantly tinkering with allowances is problematic at a time when we need people in all income groups to be confident in the pensions system as automatic enrolment is rolled out.

‘There is a danger that today’s announcement suggests even to those not directly affected by the changes that you won’t be able to rely on getting what you expected from your pension.’


Why lifetime allowance is not just a headache for the rich

Reductions in the lifetime allowance over the years have meant it is now a consideration of many more workers than it once was.

For example, if someone starts their career earning £30,000 and is lucky enough to enjoy promotions and pay rises equivalent to 5 per cent a year on average over their career, they would be earning around £165,000 after 35 years of work.

If they were to contribute the recommended 15 per cent of their salary to a defined contribution pension throughout their career, and their fund grew at 7 per cent after fees, they would hit the current £1.25million lifetime allowance in their 34th year of work. Under the £1million limit, they would hit it in their 32nd year of work.

The allowance is hit sooner if they contribute more than 15 per cent, as many older workers do, or if their pay rises faster than 5 per cent a year or if their fund achieves better than 7 per cent growth.

That £165,000 salary and £1million pension pot sound like a lot of money, so many will think this is not their problem.

But it is vital to remember that you need to think of this not in terms of today’s money but in terms of what the sums will be worth in thirty-odd year’s time after inflation has eaten into their purchasing power. If you earned a £30,000 salary today and rose in line with inflation of 3 per cent a year, in 34 year’s time you would earn £83,000.