Chapter 26 Pension Schemes Flashcards
pension funds and retirement benefits
Pension funds – contributions to pension funds eligible for tax relief are restricted depending on the level of the taxpayers earnings, taxpayers with higher earnings can made higher contributions. A registered pension funds will not pay income tax on any growth of the fund. There are two types of pensions money purchase schemes and defined benefit schemes. All personal pensions are money purchase scheme, whereas occupational schemes can be both. With a money purchases scheme the money invested is used to purchase units in the fund and the value of the units depend on the underlying investments by the fund manager, there is no guarantee of the pension benefits, this scheme is also called defined contribution schemes. In a defined benefit scheme, the benefits are dependent and the employees salary and length of service, rather than the size of the fund.
Retirement benefits – money purchase schemes
Once an individual reach 55 they are entitled to draw benefits from a pension fund. They can:
• leave the pension untouched, the pension can still grow, and the individual can make contributions until the age of 75
• take the whole pot as cash. The first 25% will be tax free and the rest will be taxed as non-savings income
• use the pot to buy an annuity. Up to 25% of the pot can be taken as a one-off tax-free lump sum and the rest converted into an annuity which then provides a guaranteed income for life. The income from the annuity will be taxable as non-savings income
• use the pot as a flexi-access drawdown. Up to 25% of the pot taken out as a one-off tax-free lump sum with the reminder reinvested by the pension provider into investment funds designed to provide regular pension income. The pension income is taxable as non-savings income. This allows individuals to take taxable income when they like.
• Take small cash sums from the pot. The individual will use the pension pot like a bank account and take money when needed, undrawn amounts remain in the pension and continue to grow tax free. For each cash withdrawal the first 25% is tax-free and the rest is taxable.
• Mixing and matching. For example, individuals can take the first 25% tax free and then split the rest between an annuity and flexible drawdown. Tax will be deducted at source from taxable payments by the pension provider. The total amount that can be taken as a tax-free lump sum is restricted to 25% of the lifetime allowance (currently £1.055 million).
maximum contributions, relevant earnings, tax relief for contributions, net pay arrangements, employer contributions and annual allowance
Maximum contributions – the maximum contribution to a pension fund that a taxpayer can obtain tax relief for a year is 100% of his relevant earnings. Anybody can pay £3,600 per year into a pension scheme regardless of their earnings. Contributions are not permitted by taxpayers over the age of 75.
Relevant earnings – this is employment income including benefits, trading income and furnished holiday lettings.
Tax relief for contributions – tax relief is obtained on pension contributions by relief at source and under net pay arrangements. Relief at source applies where contributions are made to personal pension scheme. Payments made to a pension scheme are made net of 20% tax. Therefore, when a pension contribution is made the original basic rate limit is extended by the gross amount of the pension contribution.
Net Pay arrangements – apply to occupational schemes. The employer will subtract the employee’s gross contributions from the net pay to PAYE. Pension contributions do not receive relief from national insurance contributions.
Employer contributions – if an employer contributes to an employee’s pension scheme, this is a tax-free benefit. You do not get any further tax relief from this. Employer contributions are considered for the purposes of the annual allowance.
Annual allowance – the annual allowance for 19/20 is £40,000 this allowance is tapered in respect of high-income individuals. The pension input is compared with the annual allowance, pension input is employer and employee contributions. An individual’s allowance for a tax year is increased by any unused annual allowance of the previous three tax years. When calculating the amount of any unused annual allowance the current year annual allowance is used in priority. After that any unused allowance is done on a first in, first out basis. The allowance can be carried forward provide the individual was a member of a registered pension scheme in that year.
tapered annual allowance for high income, annual allowance charge and lifetime allowance
Tapered Annual Allowance for high income individuals – the annual allowance is reduced by £1 for every £2 of adjusted income in excess of £150,000. However, the annual allowance cannot be reduced to below £10,000. An individual is a high-income individual if they have threshold income over £110,000 and adjusted income over £150,000.
Threshold income is the net income for tax purposes less the gross amount of any pension contributions for which basic rate tax relief has been given at source. When an individual’s taxable income before personal allowances but after deducing the gross amount of personal pension contributions does not exceed £110,000 the tapering provisions will not apply and there is no need to calculate the adjusted income.
Adjusted income is the net income for tax purposes, then add any pension contributions for which the employee has received relief as a deduction in arriving at employment income. Then add any pension contributions paid by the employer.
Annual allowance charge – the excess of the available annual allowance is charged to income tax. The rate of tax depends on the individual’s taxable income. The excess pension input is charged at the rate which would apply if the excess were the top-slice of taxable income for the year.
Lifetime allowance – a lifetime limit is placed on the total value of the pension fund that can benefit from tax relief. The lifetime allowance is £1.055 million. When pension funds exceed the lifetime allowance, a tax charge will be levied on the excess. This is the lifetime allowance charge. There are 2 rates, 55% if the individual chooses to take the excess as a lump sum or 25% if the individual chooses to leave the excess in the fund. In the second case a further charge will arise if cash is withdrawn from the fund because it will be treated as taxable income.
