Tax Rules Governing the Treatment of Income and Pensions
In the UK, contributions to a registered pension scheme by an individual, employer, or third party are unlimited. However, there are some important tax implications that should be taken into consideration before making the decision to contribute to a pension and how much should the contribution should be.
A relevant UK individual is defined as someone who who has relevant UK earnings chargeable to income tax for the tax year, or is resident in the UK at some time during that year, or was resident in the UK at some point during the last 5 years, or has income arising from patents which is treated as earned income.
A UK relevant individual can receive tax relief on relevant UK earnings amounting to the higher of 100% or 3,600 GBP gross pa. This does not include employer contributions. Relief can only be given if the receiving pension operates a relief at source system. No relief is available for those aged 75 and over.
The Annual Allowance is a limit on pension contributions that states that a contribution over 40,000 GBP in the tax year will attract a tax charge on the individual at their marginal rate of tax. Irrespective of who makes the contribution (employee, employer, third party). From 6 April 2016, the annual allowance reduces by 1 GBP for every 2 GBP of adjusted income over 150,000 to a minimum of 10,000 GBP. For example, an individual earning 180,000 of adjusted income would have an annual allowance of 25,000.
Contributions to a personal pension and stakeholder pension are always made net of basic tax rate. This is called pension tax relief at source (PTRAS). Any higher or additional rate of income tax must be claimed via self-assessment. Reclaiming tax relief through tax codes or self-assessment is known as ‘relief on making a claim’.
Another form of tax relief is called a net pay arrangement. This is when members of a group occupational pension scheme have their pension contribution deducted from their gross pay which means they will receive their full marginal rate of tax relief at the outset. The employee still pays national insurance contributions (NICs) on the gross salary before the pension deduction. This means the individual does not need to claim the higher or additional tax back as in the PTRAS method.
Salary sacrifice is when an employee agrees to forgo their salary in return for a pension contribution to a pension scheme on their behalf. Both employer and employee save national insurance (NI) on the amount that is sacrificed.
Save more and reduce tax (SMART) is a variation of salary sacrifice where the employee ends up with the same take home pay as they would have if they had made the pension contribution themselves. The employee sacrifices the difference and the employer contributes this amount (potentially increasing NI savings).
Employer contributions are a deductible business expense and as such are tax relivable for the employer. The employer does not pay the tax for any contribution that when combined with the employees own contribution takes them over the employees annual allowance. An employer can contribute to any number of pension schemes on behalf of an employee and there is no limit on contributions on which the employer can gain relief.
Sole traders and partnerships will receive income tax relief if the employer is a limited company (relief against corporation tax). Although contributions are unlimited, they must meet the criteria for allowable deductions which is to pass the wholly and exclusively test for the purpose of trade.
Directors often arrange to take their remuneration so that they have a small amount of salary with the majority taken as a dividend. No NI is paid on the dividend which is the main reason for this. The tax free dividend allowance is currently (2,000 GBP reduced from 5,000 GBP). It is worth noting that dividends are not classified as relevant UK earnings for tax relief purposes.
The employer can pay the contribution into the pension scheme on their behalf of the directors or the directors salary can be increased for the tax year to cover the contribution. If the contribution is made by the employer, it will need to pass the wholly and exclusive test.
Registered pension schemes grow mainly free from tax which should ensure that they have the opportunity to grow at a faster rate than any other form of investment.
No income tax liability on income from investment, deposits or underwriting commissions that would be chargeable under the Income Tax Act 2005 (Income trading and other income act, ITTOIA).
The current tax regime imposes few restrictions on the type of asset although there are taxes in relation to certain types of investment, those aimed at taking value out of the pension. There are also tax consequences from investing in personal property and personal chattels.
There is no restriction in entering into commercial or trading activities but as income will not be from investment, there is a liability to pay income tax on the trading activity.
FURBS – Funded Unapproved Retirement Benefit Schemes
Initially set up to provide benefits for employees caught by the pensions cap (limit on the value of payouts). No new Funded Unapproved Retirement Benefit schemes have been set up since A day. IHT is payable on contributions made after A day and not on the scheme before A day.
EFRBS – Employer Financed Retirement Benefit Schemes
Unregistered scheme that replaced the FURBS. Used if they have maximised allowances or plan to retire abroad. Can be set up in the UK or offshore. Set up in a discretionary trust with a provision that benefits will be paid for families and employees in retirement. Benefits are paid to the member as an interest free loan which is repaid on death from the deceased estate.
The advantages of FURBS and EFRBS have the ability to invest a large amount in residential property. Member can save over the LTA and not be restricted. It is possible to take loans at low interest. Benefits do not form part of the members estate.
Disadvantages are that benefits are subject to income tax, heightened administration, the employer is subject to tax and NI on the contribution as if it were a payment to the employee.
State pensions are liable to income tax. There are no further NI to pay once an individual has reached state pension age.
Primary Protection – Only available if the individuals pension rights were valued at more than 1.5m on 5th April 2006. A primary protection factor is then calculated using the (val-1.5m)/1.5m. This number is rounded to 2dp and then added to 1 to be applied to any existing lifetime allowance amount. This is known as the underpinned LTA. Contributions are still allowed after applying for primary protection.
Enhanced Protection – Removes the LT for everyone with pre A Day (6 April 2006) benefits, irrespective of fund size. No lifetime allowance charge at crystallisation and future growth is protected. No further contributions can be made or benefits accrued except death in service cover (Pre 6 April 2006) and NI rebates to contracted out schemes
Fixed protection (2012) – Reduction in LTA from 1.8m to 1.5m. LTA retained at 1.8m if applied for before 5th April 2012. An individual cannot have fixed protection if they have primary or enhanced protection.
Fixed protection (2014) – As above, reduction from 1.5m
Individual protection (2014) – As above but based on the value of their pension at 5th April 2014 up to a max of 1.5m and min of 1.25m.
Fixed protection (2016) – As above, reduction of LTA to 1m on 6th April 2016. No end date for applications.
Individual protection (2016) – Fixed at value of the fund or 1.25m. Does not require benefit accruals to cease but any value above the protected LTA will be subject to the LTA charge.