Six key points for pension savers as new tax allowance rules come in

In an overhaul of pension contribution allowances, which came into force on Thursday 6 April, he raised various limits on how much can be saved into and amassed in pension pots while benefiting from tax relief and not incurring excess tax charges - and in the case of the lifetime allowance removed the charge altogether.[1]  

Gary Smith, Financial Planning Partner at wealth management firm Evelyn Partners, says one basic message is that, if your pension fund exceeds or is close to the current lifetime allowance of £1,073,100, then the removal of the LTA charge means that you can for the moment pay more into your fund and not have to pay punitive tax charges when drawing money out.

“One perhaps unintended consequence of this could be that some savers who had been looking at retiring in the next couple of years might now be able to bring the date forward, taking advantage of the removal of the lifetime allowance charge,” he says. “Because the amount they will now receive after age 55 could be significantly higher than previously expected.”

He adds: “While the LTA charge is removed from 6 April, the Finance Bill abolishing the LTA altogether from April next year, and detailing the new arrangements sketched out in the Budget, is not yet finalised. So it might be premature to assume that the grittier fine print will be set down as suggested by recent HMRC guidance for the 2023/24 year.

“That together with the inherent complexity of the rules old and new, and the implications of a possible reversal to the policy from a future government in a couple of years’ time, mean that this really is an area where expert financial planners – and preferably ones with specialist knowledge or a good technical team behind them – prove their worth.”

Here are some key issues and implications around the changes coming in for the new tax year.

1. Path opened up for some to resume saving with employer contributions

Some employees may have opted out of their workplace pension scheme because they were previously close to breaching the lifetime allowance. With the changes, it could be beneficial to start paying into a plan again, particularly to take advantage of any valuable pension payments from the employer.

Likewise, the increase of the money purchase annual allowance from £4,000 to £10,000 could mean that if you have already drawn flexibly on your pension but want to return to work, you can re-join a workplace pension scheme and take advantage of employer contributions again.

2. A pension could be funded by up to £180k in the 2023/24 tax year

The raising of the annual allowance in the Budget to £60,000 alongside the scrapping of the lifetime allowance charge significantly increases the scope for some savers who are still earning to boost their pension pots. By using three years’ worth of carry forward allowances at £40,000 each, as much as £180,000 could be ploughed into a defined contribution pension pot in the new tax year.

That’s not to say it will be the best policy for everyone, as this depends on each individual’s overall financial circumstances. But, for instance, for someone in their early 50s who has a large available lump sum or bonus to place, this option could be attractive, particularly if they are a higher or additional rate taxpayer. They will benefit from tax relief at their marginal rate on the contribution as well as being able to access 25% of their pot tax-free at age 55 (rising to 57 in 2028). The removal of the LTA charge means that any excess over and above the LTA (currently frozen in 2022/23 at £1,073,100) will not suffer a lifetime allowance tax charge at the time of drawing on the funds - for the moment at least, as a future government could reinstate it.

Those using carry forward, however, do need to have current year earnings equal to or in excess of the proposed contribution and have to max out the current year’s allowance first, before utilising previous years’ unused allowances. That means it’s probably mainly the self-employed or business owners who will be able to contribute sums approaching this eye-catching maximum, particularly as the highest earners are still subject to the tapered allowance.

3. The highest earners will still struggle to make big contributions

The complicated and restrictive tapered annual allowance remains in place, albeit at a raised floor of £10,000 a year, up from £4,000 in 2022/23. For each £2 that someone’s income exceeds the new adjusted income limit of £260,000 (up from £240,000 in 2022/23), their annual allowance will be reduced by £1.[2] This means that anyone with an adjusted income of £360,000 or more will be subject to an annual pension contribution limit of £10,000 before tax charges apply.

Even someone earning £240,000 would have to contribute 25% of their gross salary - in total, including employer contribution and reliefs - to hit the new annual £60,000 limit, so for many employees the new annual allowance will mainly be of benefit if they have a lump sum, bonus or windfall to boost their contributions outside of their regular salary related payments. If a high earner is subject to the taper and has a lower-earning partner or spouse who is not using their full £60,000 annual entitlement, then there is the option to transfer funds so both allowances are fully utilised – although this could lead to complications in the event of separation.

The Chancellor has chosen to maintain ‘threshold income’ at £200,000, rather than increase this to £220,000, in line with the increase in the ‘adjusted income’ level. This might make it harder for some to bring their position below the ‘threshold income’ level and avoid any tapering of the Annual Allowance.

4. Those without relevant earnings – like some BTL landlords – will still only be able to contribute £3,600

Personal contributions benefitting from tax relief are restricted to the lower of 100% of relevant UK earnings, which can include a variety of payments but for most people is mostly comprised of income from work or your available Annual Allowance.[3] So for an employee without extra sources of relevant income, their own annual contributions – excluding employer top-ups - are limited to their salary, if it is less than the annual allowance. For someone without any relevant earnings, such as a child or retiree, the limit is still just £3,600 gross (or a £2,880 plus relief) – a level which has been frozen since 2001, and would now be set at more than £6,300 if it had been raised with inflation.

Pensions, dividend and most rental income do not count as relevant earnings. This has been a matter of frustration for some buy-to-let landlords who can find that their rental incomes are not treated as relevant earnings and therefore, if that is their sole source of income, they are severely restricted on pension contributions. However, earnings from property are a complicated area, and it’s notable that ‘income from a UK and/or EEA furnished holiday lettings business’ is considered relevant earnings for pensions purposes.

5. The frozen tax-free lump sum will shrink in real terms

Alongside the scrapping of the LTA charge, the maximum tax-free lump sum that you will be able to take has been capped at a quarter of the current LTA of £1,073,100. In other words, however much a saver boosts their pension pot above £1,073,100, they will not be able to withdraw a quarter of their total pot tax-free, but rather they’ll be limited to a tax-free lump sum of £268,275. The Government has stated that it intends to abolish the LTA in a future finance bill and it could be that this limit is frozen indefinitely, so the tax-free lump sum will shrink in real terms, and for many savers could dilute the benefits of further pension saving.

As income taken from a pension in drawdown is subject to tax as earnings, if the saver expects to pay tax at the higher or additional marginal rate in retirement then the attractions of increased pension saving reduce as the tax-free lump sum becomes a smaller factor.

6. Those with LTA protections should tread carefully

There was some uncertainty after the Budget as to whether those with enhanced or fixed protection against historic cuts to the LTA could resume pension contributions and if they could whether they would surrender their entitlement to a larger tax-free lump sum, or be subject to the new cap of £268,275.

HMRC has since confirmed that those with protection will retain entitlement to a larger tax-free lump sum if they resume contributions in the new tax year, which will depend on the value of their pot on 5 April, and be capped at 25% of the LTA at which their protection was fixed. This figure could vary if an individual has already taken some benefits from their pension.

But that doesn’t mean that they ‘should’ start boosting their pensions immediately – not least because the rules around the abolition of the LTA in April 2024 will not be finalised until a new Finance Bill comes into force. Even now, with HMRC’s ‘clarification’, the rules are extremely complex and difficult to apply, and last but not least, a new government could change the tax landscape again. So anyone with savings large enough to face these issues would be wise to take professional financial advice.

NOTES

[1] The headline measures, coming into force from 6 April, are (in the words of the Treasury):

• The Annual Allowance increases from £40,000 to £60,000
• The Money Purchase Annual Allowance and minimum tapered AA increase from £4,000 to £10,000
• The adjusted income level required for the tapered AA to apply to an individual increases from £240,000 to £260,000.
• Nobody will face a lifetime allowance excess charge (55% tax on lump sums and 25% on pension income) from April 2023. At a future fiscal event, the government will make the necessary changes to entirely remove the LTA from pensions tax legislation.
• The maximum amount that most individuals can claim as a pension commencement lump sum is currently 25 per cent of their available LTA at the time this sum is taken. This measure sets a PCLS upper monetary cap of £268,275 (25 per cent of the current LTA). However, those individuals who already have a protected right to take a higher PCLS will continue to be able to do so.

[2] An explanation of adjusted and threshold incomes for 2022/23 can be found here: https://www.gov.uk/guidance/pension-schemes-work-out-your-tapered-annual-allowance#adjusted

[3] An explanation of relevant UK earnings can be found here: https://www.gov.uk/hmrc-internal-manuals/pensions-tax-manual/ptm044100#earnings