Pensions Simplification

A Guide to the New Pension Rules

Lifetime Allowance

After 6 April 2006 the maximum amount anyone can have invested in their pension funds when they choose to take their pension, without potentially being subject to a tax charge, will be £1.5m; this figure is proposed to increase to £1.8m by 2010. The value of your pension funds will be calculated in different ways depending on the type of pension arrangement you have.

Where individuals exceed the lifetime allowance, or are likely to when benefits are taken, there are two forms of protection that can be applied for which will allow the funds to be protected against tax charges. These are Primary Protection and Enhanced Protection.

Primary protection is only available for those with funds in excess of £1.5 million at A Day. Effectively you secure your own personal lifetime allowance, which can grow at an agreed rate. When benefits are taken the fund is measured against the lifetime allowance in force. Should fund growth, contributions or a combination of the two have increased the total funds above the personal lifetime allowance secured plus the permitted rate of increase, benefits taken above this level will be subject to a tax charge of up to 55%. In this situation ongoing monitoring of fund growth and contributions is therefore important to avoid accruing benefits that will be subjected to a penal rate of tax.

Under Enhanced protection, there is no restriction on the minimum size of the fund that can be protected. The total fund and future growth is fully protected against any tax charge when benefits are taken. However, this tax amnesty is only allowed on the basis that no further contributions or pension accrual is allowed from 6th April 2006.

Making the most of the protection options. If you require enhanced or primary protection (or both enhanced and primary protection) at A-Day you may want to consider maximising this protection by increasing your pension contributions now.

Tax-Free Cash

After A-Day everyone will be allowed to take the lower of 25% of their pension benefits value or 25% of the lifetime allowance as tax-free cash. Depending on how you choose to take your income you may be able to get more than 25%. For some people the new rules may reduce the amount that can be taken as a tax-free lump sum. If you have been topping up your employer's pension with Additional Voluntary Contributions (AVCs) you should be able to take some tax-free cash. If you are over 50 before A-Day, you may be able to take your entire fund as a tax-free lump sum without affecting your lifetime allowance. If tax-free cash is an important issue for you, you need to find out how you are affected and what action can be taken to protect sums currently greater than 25%.

Annual Allowance

At the moment the amount that you and your employer can pay into your pension plan each year is limited by the Inland Revenue rules relating to earnings and maximum pension benefits. After A-Day there will be an annual allowance of £215,000 which will govern the amount you can pay in or the amount your benefits can increase by each year without incurring tax charges. The annual allowance is proposed to increase to £255,000 by 2010. This will work as follows:

You will be able to get tax relief on contributions up to 100% of your earnings and your employer may get tax relief no matter how much they pay. But there will be tax charges applied to you where the total amount of contributions paid for your benefits exceeds the annual allowance or if your benefits value increases by more than certain limits.

If you and/or your employer currently contribute more than the annual allowance, or could potentially contribute more prior to A-Day you need to find out how the new rules will affect you.

Trivial Pensions

If the total benefits value of all your pension plans is £15,000 or less at 6 April 2006 then you may be able to take this as a lump sum. 25% of the lump sum will be tax-free with the remainder being taxed as earned income.

You should review all your pension plans and have their value calculated. If you are due to retire in the near future and your pension plans are worth less than £15,000 and you want to maximise the lump sum payment from them, then you may want to consider delaying your retirement until after 6 April 2006.

Earnings Cap

Currently anyone who joined their employer's pension scheme after May 1989, or who is in a personal pension, is subject to the earnings cap set at £105,600 for tax year 2005/06. The earnings cap in effect limits the amount of pension benefits available at retirement or contributions that someone can pay into their pension fund. The earnings cap will be removed from 6 April 2006.

If you currently earn more than the earnings cap, you need to know how its removal will affect your pension rights.

Retirement Annuity Contracts

Retirement Annuity Contracts, sometimes known as section 226 plans, will be subject to many changes. One of the changes which could affect you is the amount of tax-free cash that can be taken. This may cause problems if you were planning to use such a plan to repay a mortgage. Also, the ability to use unused tax relief from previous years to pay more into the plan than usual will be removed. This could restrict the amount that can be paid in after A-Day. The good news, however, is that the minimum retirement age for these contracts will be reduced from age 60 to 50 from 2006, rising to 55 in 2010.

If you have one of these plans you need to know how these changes will affect you.

Minimum Retirement Age

From 6 April 2010 the minimum retirement age will be increased to age 55. The good news, however, is that you don't need to stop working to draw benefits from your pension scheme.

If you aim to retire before age 55 after 2010 you may need to review your pension arrangements and make alternative provision.

Taking Your Pension Benefits

The new rules will allow you to take your pension benefits in one of four ways:

1. An income paid directly from the pension scheme: this kind of pension is usually paid from certain types of company pension schemes.
2. Regular payments for life: This is when you use your pension fund to purchase an annuity from an insurance company. The annuity is guaranteed to pay you a regular income for the rest of your life and may also include a reduced pension for your spouse/dependants when you die.
3. Income withdrawals: This is the type of arrangement that will suit those who don't require their entire fund to be used to purchase a pension. This type of arrangement is only available until age 75.
4. Alternatively secured pension: This is similar to income withdrawals but is only available after you turn age 75.

If you are due to retire before or shortly after 6 April 2006 you need to be aware of these new options as there may be advantages in taking your benefits now or waiting until after A-day.

Death Benefits

The new rules require trustees to pay out death benefits within two years of a person dying. Any payments made outside of the two-year period will be classed as "unauthorised payments" from a pension scheme and will become subject to a 40% tax charge. This basically means that your spouse or dependants must inform everyone with whom you have a pension within two years if you die before retirement. In addition, Death in service benefits will also count towards the lifetime limit; this includes lump sums from employer sponsored Group Risk arrangements. This effectively restricts the level of tax free benefits payable from all sources to £1.5 million. Will you be affected?

Now is a good time to put your papers in order. You should record details of every pension arrangement you have, who it is with and who to contact.

Contracting Out

It is also proposed that tax free cash can be taken from Protected Rights Plans and the requirement for increasing benefits will be removed. In addition, benefits will be able to be taken from age 50 between April 2006 and April 2010, and from 55 thereafter.

If you are currently contracted out you should review the suitability of contracting out in light of your attitude to risk together with the reduction in the levels of National Insurance rebates and protection offered by the State. Contracting out does offer a greater amount of flexibility although there is no guarantee that the resultant benefit will match that provided by the State.

For more information either email a-day@lucasfettes.co.uk or telephone 0845 3578910.

This information is based on our understanding of current legislation/practice and the legislation contained within the Finance Act 2004.