PENSIONS HAVE GOT A LOT
SIMPLER
Pensions are among the most
tax-efficient and effective ways to save for retirement, but
working out how much to save and deciding which type of pension
is best often feels like a complicated business.
The good news is from 6th
April 2006, so-called “A-Day”, life got simpler for retirement
savers as the government brought in a new simplified set of
rules, effectively shelving the eight previous tax frameworks
for pensions, which made life very complicated for everyone.
The changeover means it ought
to be easier than ever to begin calculating how much you ought
to be saving for your future.
The new rules have given
savers far greater freedom in how and when pension benefits are
taken.
Pensions have long offered attractive tax breaks. This means for
higher rate taxpayers a contribution of £100 only costs £60, for
basic rate taxpayers the same contribution costs £78, as the
Government providing the £40 and £22 respectively in tax relief.
Certain elements of pension simplification create even more
generous tax breaks for some savers. For example, those paying
into any pension arrangements which under the old rules did not
allow the plan holder to take any tax-free cash from the fund
when they come to take benefits from the pension, now find that
they can now take 25 per cent of the value of the fund as a
tax-free lump sum.
Simplification ought to have
taken some of the mystery out of pensions, but with the new
flexibility has come new dilemmas for would-be savers, as well
as those already building up their retirement nest eggs.
For this reason, many would do
well to discuss with an independent financial adviser what steps
they might need to as a consequence of the changes made on the 6th
April 2006, and also how their pension needs might be met
because of the rule changes.
In this guide we break down what has changed and what pension
simplification means for your retirement saving options.
A-DAY: THE MAIN CHANGES
One of the main changes is
that, regardless of whatever type of pension you may have, you
and your employer will be able to pay up to one annual allowance
for that tax year. This amount is up to 100 per cent of your
earnings and for the tax year 2007/08 this allowance is capped
at £225,000, with the limit set at £3,600 for low or non-earners
paying into personal and stakeholder pensions.
The single allowance rule does
away with the sometimes baffling calculations individuals faced
under the old tax regulations in order to work out what they
could pay into their pensions.
It is hoped the end of
complicated calculations removes one of the barriers preventing
people from saving more.
A further move designed to
encourage us to save more is the greater ease with which people
can save into a number of different pensions at the same time
under the new rules, compared with the old.
That said, within the
contribution limits, the onus is still on individuals to work
out how much they ought to be saving and how much they can
realistically afford to put aside.
It remains as important as
ever to strike the right balance between saving enough for
retirement while not leaving yourself either short of cash month
to month or for rainy days and predictable large costs such as
school or university fees, even your children’s weddings.
An independent financial
adviser (IFA) will be able to steer you through this sometimes
tricky path and find the right balance, by looking at your
retirement savings and your entire financial circumstances
together.
They will also help you work out how much you can afford to save
and what you should be aiming to put aside over the years and
importantly, how much you will need to save now to maintain the
quality of life you want in retirement.
Research in 2005 by the Association of British Insurers
indicated that more than 60 per cent of people are not confident
that they will have enough money to live comfortably during
their retirement. With the right advice, you need not be among
this number.
Anyone planning for their retirement, however distant, ought to
recognise that the Government is looking to discourage people
from retiring early. The earliest age pensions can be taken
increases from 50 to 55 in 2010. Anyone planning to retire early
in the next five or so years will almost certainly need to speak
to an adviser to work out how the change will impact upon their
plans.
MORE TAX-FREE CASH
Under the old pensions rules some plans, such as certain
occupational schemes, allowed savers to take more than 25 per
cent of their fund as tax-free cash when the time comes to take
the benefits. However, others, such as top-up pensions
Additional Voluntary Contribution schemes, did not allow any
tax-free cash to be taken.
Legislation now allows all pensions policyholders to take 25
per cent tax-free cash on the benefits built up after 6th
April 2006, regardless of the kind of scheme it is. (The amount
those in occupational schemes will be able to take as tax-free
cash may depend on whether the trustees have changed the scheme
rules, meaning individuals may need to contact their scheme’s
trustees to establish what the situation is).
Permitting all pension policyholders to take 25 per cent
tax-free cash levels the playing field between different
pensions. This means it will be a good idea to re-consider which
pension arrangements are the most attractive to you with the
help of an expert IFA.
LIMITS ON THE SIZE OF YOUR PENSION
There is a limit on the amount of money built up within your
pension. In the tax year 2007/2008 this amount is £1.6 million,
with the threshold expected to rise over the years to allow for
the impact of inflation (see table 2).
This is also the maximum amount that can be paid out as a tax
free lump sum to your beneficiaries in the event of your death,
giving much greater flexibility to provide death benefits via
pensions after A-Day.
Introducing one lifetime limit for pension fund size effectively
bins the sometimes complicated calculations savers could be
forced to work through under the old pension rules.
A further innovation under the new rules is that the value above
the lifetime limit will be subject to a new tax charge known as
the lifetime allowance charge, or recovery tax, which
will be charged at up to 55 per cent.
This measure is aimed at curtailing the amount of tax relief
individuals can get from pensions.
A pension fund of more than £1.6 million might sound like the
preserve of the very rich, but it is likely that more
individuals than they realise will be in danger of breaching the
lifetime limit and potentially facing a 55 per cent tax hit.
This is because the lifetime limit relates to your entire
pensions savings, including any private pensions, occupational
pensions and free-standing additional voluntary contributions;
so many people who think they are well below the lifetime limit
might have more than they realise when they take into account
the full picture.
This means it will be essential for certain pension savers
likely to be on the brink of the lifetime limit to keep on top
of the size of their total pension fund as they build it up.
Dealing with the paperwork and calculations may seem daunting,
but a pensions IFA will able to project realistically the value
of retirement savings into the future.
PROTECTING YOUR PENSION
Pension savers who have already bust the £1.6 million pension
threshold or are concerned about doing so are strongly
recommended to seek professional advice on how to shield their
savings from the lifetime allowance charge or, alternatively,
how to maximise tax breaks under the current rules.
It is possible to register your pension fund value built up
before 6th April 2006 to protect it against the lifetime
allowance charge and pension savers have until April 2009 to do
this, although the sooner you understand your options the better
you can plan accordingly.
The first thing you may want to consider if you are at or near
the lifetime limit is getting a valuation of your entire pension
savings, before considering putting certain protective measures
in place, which will harbour the fund from the lifetime
allowance charge.
An IFA will be well-placed to guide you through this rather
complicated area, but generally speaking, there are two levels
of protection available.
So-called ‘primary protection’ is available where the
value of pension funds was over the £1.5 million lifetime limit
on A-Day,
Going for primary protection will shield the value of your
pension you have already built up and can potentially allow it
to continue to grow in line with the increases in the lifetime
limit without triggering the lifetime allowance tax charge.
‘Enhanced protection’ is available to any fund regardless
of its size. Roughly speaking, this shelters not just the
current value of pension savings, but also the full value of
future investment returns, without incurring a tax penalty.
However this option is only available where no further
contributions have been made or will be made in the future or,
if you are in a final salary scheme, that your benefits have not
and will not in the future increase above certain limits and no
new benefits are built up in respect of your employment after
A-Day.
Most experts agree ensuring you have a plan in place to protect
your savings because of the impacts of pension simplification is
an area where you will almost certainly need advice and struggle
to do-it-yourself. Anyone with a pension pot worth more than
£1million will almost certainly need guidance.
NEW OPTIONS ON PENSION BENEFITS
If you have a money purchase
pension (where the value of the pension fund at retirement is
based on the amount paid in and how much this has grown by, such
as personal and stakeholder pensions), then when you come to
retire your income is normally secured by the purchase of an
annuity (compared to final salary schemes where income can be
paid out direct from the pension fund).
An annuity is effectively a promise to pay you an income for the
rest of your life and is sometimes described as ‘insurance
against living too long’, because with an annuity, your income
from it lasts as long as you do.
Individuals are compelled to take benefits from their pensions
by age 75 as they are now, however, the new pensions rules offer
far greater flexibility over how benefits are taken.
For example, since 6th April 2006 we have seen the
introduction of new types of annuities.
‘Limited period annuities’ permit you to buy annuities in
smaller chunks, each spanning a five year term, while the rest
of your fund can be left invested. This will give individuals
more choice on when to buy annuities and also allows them to
maintain more control over their pension fund.
New ‘value-protected annuities’ respond to one of the key
criticisms of annuity, that is, if you die very shortly after
buying an annuity, your family loses out on your life’s savings
because the money is absorbed by the collective fund of an
insurance company’s annuity policyholders.
The most common criticism of traditional annuities was that if
you die ‘early’ your money is effectively absorbed and
re-distributed among those who live longer.
Roughly speaking, under value protected annuities, if on death
the money
used to purchase the annuity has not been used up by an
individual and they are under age 75, the balance can be paid to
the policyholder’s estate after a tax charge of 35 per cent has
been deducted.
However, it is essential to stress this potential benefit will
be reflected in the rates for protected value annuities, which
could be notably lower than on regular annuities.
‘Unsecured pensions’ are also available. This is similar
to income drawdown under the old rules, where investors do not
buy an annuity, but can take the tax-free cash sum and leave the
remaining fund invested and income is taken from the invested
fund and returns. Unsecured pensions can be used up to age 75
and policyholders can take up to a maximum amount up to 120 per
cent of the annual income payable from a single life, level
annuity. There is no minimum amount.
OTHER PLANNING OPPORTUNITIES
Pension simplification has created many other planning
opportunities, whether you are self-employed or within a company
pension scheme, and whether you have any existing pension
provision or not.
If you have old pension schemes which are no longer active,
perhaps because you left the employer who provided the scheme,
or if you have a pension contract you are not familiar with, you
could be well advised to seek out advice about the possibility
of transferring or at least optimising the benefits
of these pension funds.
Also if you have a small pension fund or funds when you reach
your planned retirement date, it is now possible you will be
able to take out the whole sum as a lump sum, rather than buy an
annuity. The limit for 2007/08 is £16,000, which equates to 1
per cent of the lifetime allowance.
