Pension Rules frequently asked questions

The Lifetime Allowance Charge is a charge made on any pension fund amount above the individual’s Lifetime Allowance (LTA) at the time of taking benefits. The charge is based on how the excess amount is taken. If taken as a lump sum there is a charge of 55% of the excess. If benefits are taken as income there will be a 25% charge levied on the excess amount. The charge will be taken by the pension provider before benefits are paid out. Clients can take a mixture of lump sum and income payments from the excess and the charge will be split accordingly.

For most individuals the charge only applies when the total benefits crystallised exceed the standard LTA applicable in the year the benefits are taken (£1.8 million for tax year 2011/12 and £1.5 million for 2012/13 onwards).

If a client has a protected pension age and is allowed to retire before the normal minimum pension age of 55, the LTA will reduce by 2.5% for each full year under the normal pension age that they retire. For example, if they retire at age 52, the LTA will reduce by 2.5% for each of the three years up to age 55.

Where a client has an increased personal LTA via primary protection, pension credit, or a transfer in from a recognised overseas pension scheme, this is the level which, when breached, will cause an LTA excess charge. There is no such test applied for clients whose pre A-Day funds are registered for enhanced protection.

Example 1: A client with no previously crystallised benefits.

If a client has uncrystallised funds of £3 million and only crystallises £1 million in the 2011/12 tax year there will be no excess charge levied. However, if the client was then to crystallise a further £2 million in the same tax year this would be more than the standard LTA of £1.8 million for the year, and this would give an excess of £1.2million. This excess would be subject to the relevant charge of 55% or 25% depending on how the benefits are taken.

Example 2: A client who has previously crystallised some pension funds.

A client had crystallised pension benefits in tax year 2006/07 worth £500,000. This represented 33.33% of their LTA. In the 2011/12 tax year the client is looking to crystallise their remaining pension benefits worth £2 million. The standard LTA in the current year is £1.8 million but the client has already used up 33.33% of this figure with previous crystallisation events, which leaves scope within the LTA of £1,200,060. As the client is crystallising £2 million, this will be in excess of their remaining LTA to the value of £799,040. This excess would be subject to the relevant charge of 55% or 25% depending on how the benefits are taken.

The Lifetime Allowance Charge will be made for any individual who crystallises pension funds that are partially or completely in excess of the Lifetime Allowance (LTA) applicable to the tax year the benefits are crystallised.

The exceptions to this limit are where individuals have an increased personal LTA or have primary or enhanced protection of their pension funds.

Increased personal Lifetime Allowance

If a client has been subject to pension sharing on divorce prior to A-Day, and has accrued a pension sharing credit from their ex-spouse, this money will not count towards the standard LTA if the client had requested an enhancement from HM Revenue & Customs ( HMRC) by 5 April 2009.

If a client has accrued previous pension benefits in a Recognised Overseas Pension Scheme and transfers the benefits into a UK registered pension scheme, they can again apply for an enhancement to their LTA. The request must be registered with HMRC no later than 31 January following the end of the tax year, five years following the tax year in which the transfer takes place.

These enhancements will give the client's a personal LTA that is basically the standard LTA plus the value of the event described above. These additional benefits have been accrued outside of the rules for personal benefits accrual under registered pension scheme legislation, and so should not impact on this entitlement (divorce benefits have been accrued by another party and overseas pension benefits have been accrued and received appropriate foreign tax relief while outside of the UK).

Enhanced protection

Enhanced protection protects the pension fund and the tax-free cash that has been built up before A-Day and completely eliminates the risk of a LTA charge being due. Where enhanced protection is chosen, no further contributions can be paid post A-Day and benefit accrual is restricted in defined benefit schemes.

Primary protection

Primary protection will give some protection to those individuals who had pension funds in excess of £1.5 million before A-Day. This protection gives the member an enhancement factor of the lifetime allowance and allows all funds accrued to reach this factor before the excess charges are made. This factor will be applied to the standard LTA and so effectively increases in line with the increases in the LTA. With primary protection further contributions and benefit accrual can be made.

To have received these forms of protection a member must have applied to HMRC for these enhancements to their standard LTA with correctly completed application forms by 5 April 2009.

The annual allowance applies in total to all increases in pension entitlement an individual may have. The list below details how these increases are valued when testing against the annual allowance:

Benefit value and calculations.

Money purchase arrangements – the total contributions paid in any one pension input period, excluding age-related rebates. This includes gross contributions paid by or on behalf of the individual, and their employer.

Cash balance arrangements – the increase in the value of the individual’s rights over a pension input period. When working out how much the benefits have increased by, the amount at the beginning of the year must first be increased by the higher of 5% or the percentage increase in the RPI or any other rate specified by HMRC. This is then compared with the value at the end of the year.

The rights to be valued will include partial benefits taken during the year, any rights transferred out to another registered pension scheme, and any pension debits. The value of any rights given on transfers in to the scheme and any pension credits can be excluded.

Defined benefit arrangements – the increase in the value of the individual’s rights over a pension input that started on or after 14 October 2010.. Benefits will be valued using a standard valuation factor of 16:1 regardless of age or sex. Any personal contribution the member is making in addition to the increase in member’s benefits for the year is ignored for this calculation. Any increase in lump sum rights (ie not by commutation) will be taken to be the actual lump sum and added on to the value given above.

For a pension input period that started before the 14 October 2010 but will end in the 2011/12 tax year the value of pension benefits accrued between the start of the input period and the 13 October 2010 will be valued using a 10:1 valuation factor. The accrual beyond that date to the end of that input period will use the 16:1 factor.

The rights to be valued will include any benefits taken during the year, any rights transferred out to another registered pension scheme, and any pension debits. The value of any rights given on transfers into the scheme and any pension credits can be excluded.

Deferred benefits must increase by the greater of 5% or the percentage increase in the RPI or any other rate specified by HMRC before the 16:1 factor is used.

The annual allowance for the 2011/12 tax year is £50,000, and will remain at £50,000 for subsequent tax years although indexation may apply from 2016/17 tax year.

Any divorced person who was granted a pension sharing credit prior to A-Day was able to apply for an increase to the standard LTA by the amount of the pension credit that had been received, provided HMRC received the formal application no later than 5 April 2009. Prior to A-Day these benefits had been legitimately accrued and received tax relief, and HMRC agreed that, as a result, the value should not count towards any limits set post A-Day.

Any pension debit from a pension sharing order that was granted pre A-Day is ignored for LTA purposes for the member, with the debit against their pension fund. Those people with pre A-Day pension debits will be able to fund for any pension shortfall they have suffered by using standard annual and lifetime allowance limits now available.

The same pension sharing legislation applies to both pre and post A-Day schemes; however, the way the funds are treated is a little different.

Prior to A-Day the transitional rules allowed for some form of enhancement to the LTA for pension credits, as outlined in the previous question.

However, pension sharing credits awarded after A-Day are taken into consideration as part of clients’ normal pension funds and an increased personal LTA is not usually available.

There are two exceptions to this rule.

Where the ex-spouse acquired a right to a pension credit prior to A-Day but this payment was not actually passed over to them until after A-Day, the ex-spouse was able to make an application for an increased personal LTA provided the application was received by HMRC no later than 5 April 2009.

The second exception is where a pension credit is derived from a pension in payment. In these circumstances, the ex-spouse can apply for an enhancement of the re-capitalised sum they have received. The ex-spouse will have until 31 January following the end of the tax year five years after the tax year in which they became entitled to the pension credit to register for the increased personal LTA. The reason for this exception is that the pension credit amount derives from funds which will already have been tested against the member’s LTA before the divorce. No pension commencement lump sum can be taken from a pension credit that derives from a pension in payment.

No.

If scheme rules allow, a member may make a contribution by transferring shares into their pension scheme or using other in-specie assets.

Shares may be transferred to a scheme as a contribution as long as the shares are eligible, either:

• If the shares have been gained through a save as you earn scheme, and are transferred into the pension scheme within 90 days of the member exercising the right to acquire them.
  or
• The shares have been part of a share incentive plan, and have been transferred to the pension scheme within 90 days of the member asking for the shares to be transferred to them or, if earlier, the release date in relation to the shares.

The value of the contribution for tax purposes will be the market value of the above shares on the date they are transferred to the scheme.

Other shares and other assets (eg a property) can also be paid into the registered pension scheme as an ‘in-specie’ contribution as long as the pension scheme allows for this within their scheme rules and the asset is acceptable to them.

In these circumstances HMRC insists that any in-specie transfer received must match the true contribution liability that has been made with the intention to pay the contribution by transferring assets. This can cause problems with assets being used that have a degree of market volatility and rapidly changing prices.

It is possible for an employer to pay a pension contribution with an alternative in-specie asset subject to the rules detailed above applying. Also, consideration would have to be given to the rules relating to employer related investments being held within a scheme.

There is no defined maximum contribution an employer can pay. As long as it can be proved the contribution is exclusively for the purposes of the UK business, tax relief is not restricted on the contribution an employer makes on behalf of the employee.

Any contribution made over the annual allowance will create an annual allowance charge. This charge will be levied on the member. This can cause potential problems for the member as the contribution that has been paid is a legitimate contribution and cannot be refunded, so the member will have to find the money for the charge.

Example 1:

A member earns a salary of £120,000 and makes a personal pension contribution of £25,000 gross.

The employer recognises the essential nature of this employee and contributes into their pension plan an amount of £20,000. Under these circumstances the combined pension contributions are below the annual allowance which can be paid as contributions with no annual allowance charge.

Example 2:

A member earns a salary of £220,000 and makes a personal pension contribution of £45,000 gross.

The employer recognises the essential nature of this employee and contributes into their pension plan an amount of £50,000. As the total pension contributions (£95,000) are in excess of the current annual allowance of £50,000 there is an excess of £45,000.

Although the excess has been created by the employer’s contribution, the excess charge will be levied on the member at an appropriate rate. The appropriate rate is determined by adding the amount subject to the charge to the member’s ‘net income’. The appropriate rate is:

• 20% on that much of the chargeable amount that, when added to net income, does not exceed the basic rate limit.
• 40% on the amount which exceeds the basic rate limit but does not exceed the higher rate limit,
• 50% on any part of the excess which exceeds the higher rate limit.

This charge may be avoided however by utilising pension input periods that result in pension contributions being allocated to different tax years, or by making use of carry forward of unused annual allowance from the three previous tax years.

Where a member of a defined benefits scheme has, for example, been promoted and receives a retrospective increase in benefits, the resulting increase may mean the client is over the annual allowance for the current year but may still be able to offset some or all of any excess by using the carry forward of unused annual allowance rules.

Member contributions are generally restricted by pension providers based on tax relief gained on the contribution rather than the overall size of the contribution.

In theory, a personal contribution has no restriction other than the annual allowance. However, pension providers will generally only accept tax relievable personal contributions.

For purposes of tax relievable contributions the maximum amount that can be paid is the higher of £3,600 or 100% of UK relevant earnings (ie employee earnings, self-employed earnings and patent income). These figures are always quoted on a gross basis so it should be remembered that personal contributions to personal pension based registered pension schemes will be made net of basic rate tax, with the pension provider claiming the basic rate of tax back from HMRC. If the member is a higher rate tax payer they will generally need to claim any additional relief via their self assessment forms or if they do not fill out one of these via a stand alone claim.

It should also be noted that HMRC treats all contributions from other sources, which are not seen as being from a current or previous employer, as a third-party contribution. A third-party contribution will be treated as though the member had made the contribution. This means the member will be able to claim personal tax relief at their highest marginal rate (the third-party contributor will give up all rights to the money and cannot themselves claim tax relief). The member will also have to ensure that this contribution is counted when looking at the total tax relievable contributions they can make as outlined above, as well as the total for annual allowance purposes.

A pension input period (PIP) is the period of time over which contributions are made to an arrangement that will count towards the appropriate annual allowance. The last day of the PIP will determine which tax year’s annual allowance the contributions will count against. For example, if a PIP started in June 2010 and ends in June 2011, this will count towards the 2011/12 annual allowance of £50,000.

Generally, each PIP can run for any period of time up to 12 months. However, there can only be one pension input period ending in any one tax year per arrangement.

The first PIP commences on the date of the first relievable pension contribution made to an arrangement and ends on 5 April of the same tax year, unless an earlier or later date is nominated.

A nomination date cannot be more than 12 month after the start date of the PIP. A nomination for an end date after 5 April can be made after 5 April but this cannot be a date before the nomination is made. Skandia takes advantage of the nomination process. For information on how Skandia arrangements operate please click here.

For example, Colin wants to set up a new Collective Retirement Account by making a single lump sum contribution of £2,000 on 2 January 2012. His first PIP will start on 2 January 2012 and would normally end on 1 January 2013 which will mean that the £2,000 contribution will count against Colin’s 2012/13 annual allowance.

If Colin wants that contribution to be set against his 2011/12 annual allowance he can nominate in writing at the time of making the initial contribution that the initial PIP should end on a date that is no later than 5 April 2012.

Once the first PIP has ended the next PIP will commence immediately afterwards. It will automatically last until the anniversary of the end date of the first PIP, unless a nomination is made for it to end earlier or later. The nomination must be a date in the tax year following the tax year in which the previous PIP ended in, and can’t be a date before the date the nomination is made.

For example, Sheila has a Collective Retirement Account where the second PIP started on 6 July 2011 and will therefore normally end on 5 July 2012. Sheila could not nominate an end date which fell before 6 April 2012 but could choose any date up until 5 April 2013 as long as the date chosen is on or after the date the nomination is made.

Where the employer is a limited company they can normally treat any pension contribution as a business expense and offset against corporation tax due, as long as the ‘wholly and exclusively’ rules are met in relation to the UK trade being carried out. Where the employer is a sole trader or partnership the contributions will be set against the income tax liability of the sole trader or partners within a partnership.

A registered pension scheme member will be subject to a 40% tax charge on the amount of any contribution (both individual and employer) paid in excess of the annual allowance applicable to the tax year in which the pension input period ends and where all relevant carry forward of unused annual allowances from pension input periods ending in the 3 previous tax years has been used up.

• This charge will not apply to pension savings for an arrangement in the 2011/12 tax year onwards where the individual:
  – dies
  – retires on the grounds of serious ill-health, or
  – is a deferred member of that arrangement (provided the benefits do not increase more
     than CPI or an annual percentage rate in force in the scheme rules on 14 October 2010).

Tax relief is normally granted in respect of the trading period in which the pension contribution is paid to the registered pension scheme. However, if the contribution is significantly larger than that made in the previous year it may be necessary for the tax relief to be spread over a number of years. An employer contribution needs to be spread for tax relief purposes where it:

• is more than 210% of the contribution paid in the previous chargeable period, and
• the ‘relevant excess contributions’ (RECs) are £500,000 or more.

A chargeable period is the company’s accounting period. The timescale over which a contribution is spread varies – it depends on the amount of the REC and can be between two and four years. RECs are defined as the excess over 110% of the amount paid in the previous chargeable period.

Note: Tax relief can be claimed in the current chargeable period on the excess where the employer ceases to carry on business.

Yes, it is called a short service refund. A refund can only be taken from an occupational pension scheme if the member leaves the scheme within two years. Once somebody has been in a pension scheme for at least three months they also have to be offered a transfer of benefits. This transfer value must include the value of any employer contributions. There is no statutory entitlement to a preserved benefit for those with less than two years service.

Special rules apply when benefits include protected rights.

Up to 5 April 2010 tax was deducted at a rate of 20% on the first £10,800 of the refund and then 40% on anything over £10,800. From 6 April 2010 tax will be deducted at a rate of 20% for the first £20,000 of the refund and then 50% on anything over £20,000. The scheme administrator will deduct tax from the payment and account for the amount of tax deducted to HMRC.

Employer contributions must be ‘wholly and exclusively’ for the business before they can be granted corporation tax relief by the local Inspector of Taxes.

Controlling directors often take a low salary but high dividends from the business in order to save on National Insurance contributions. If they want to make high (in relation to salary) employer pension contributions, HMRC will look at the client’s total remuneration package that includes both salary and the pension contributions being provided by the employer when making a decision relative to the authorisation of tax relief on the employer contributions.

Where there are non controlling directors or close relatives of the controlling director(s) for whom employer contributions are being made however, these contributions are unlikely to receive tax relief if they are not in line with contributions made for any other unconnected employees doing the same work within the business.

The following people will be legally classed as a dependant:

• Legally married spouse or civil partner, at date of death.
• Unmarried partner (a ‘common-law’ husband or wife or someone of the same sex can be treated as a dependant, where the relationship was one of financial interdependence).
• Children – under the age of 23.
• Financial dependant.
• Adult/child who is dependent due to mental/physical incapacity.
• Where scheme rules allow, an ex-spouse if they were married to the member when they first started to take the pension.

Lump sum return of fund and/or lump sum benefit can be taken:

• Up to an individual’s available Lifetime Allowance (LTA) tax free if the member dies before their 75th birthday. There is no LTA test from age 75 but any lump sum death benefits paid after this age will be subject to a 55% tax charge.
• Excess above the LTA subject to 55% tax charge if taken as a lump sum

and/or

Dependants’ pensions (not tested against the member’s LTA):

• Secured Pension
• Drawdown Pension including Flexible Drawdown, if dependant meets Minimum Income Requirement and the scheme offers the benefit,

If a lump sum death benefit is paid later than two years after the pension provider knows of the death, or can reasonably expected to know of the death, the payment will be treated as an unauthorised payment. See 'What are authorised and unauthorised payments?' below.

If the member was taking secured income, a dependant can take income in one of the following ways:

• Scheme pension – paying a pension for life out of the scheme assets, or by purchasing an annuity with an annuity provider. Defined benefit schemes can only offer a scheme pension. Money purchase schemes can offer this option too, but only if the dependant has the opportunity to purchase a lifetime annuity.
• Lifetime annuity – benefits are secured by purchasing an annuity from an annuity provider. Money purchase schemes have to offer an open market option.

If the member was taking drawdown pension at the time of death the remaining fund can be taken in one of the following ways:

• Capped Income withdrawal – there will be no minimum income under income withdrawal. The maximum income that can be taken is based on 100% of the annual income payable from a single life, level annuity with no guarantee. The annual income must be calculated using the Government Actuary’s Department (GAD) income factors which vary based on age, sex and 15-year gilt yield.
• If the dependant was in receipt of secure pension income of at least £20,000 a year they would be eligible to apply for a flexible drawdown facility provided that was available within the scheme holding the member’s drawdown fund on death. This would allow them to take income from the fund without limit although all income taken would be taxed as earned income at the highest rate(s) of income tax they are liable to
• Short-term annuity – short-term annuities will allow a dependant to purchase an annuity, or a series of annuities (on the open market, if required), with funds held in an unsecured pension fund. The income generated from the short-term annuity cannot exceed the maximum income available through use of income withdrawals. The annuity term cannot be more than five years.
• Lifetime annuity benefits are secured by purchasing an annuity from an annuity provider through the use of an open market option

If there are no qualifying dependants on death the value of the plan can be paid to a registered charity. This payment will not incur any charges and can be the full pension fund value.

If a member was taking a secured income via a lifetime annuity then:

• their dependant can take a lump sum (known as an annuity protection lump sum) that would be taxed at 55% (if the member had chosen this option when they took secured pension), or
• their dependant could continue to receive annuity payments until the end of any guarantee period.

If the member was taking drawdown income then:

• The dependant could take a lump sum, less 55% tax.
• A scheme pension could be purchased, for the dependant.
• A lifetime annuity could be purchased (money purchase scheme only).
• The dependant could choose to take drawdown. This option has to be secured initially under the same arrangement as the death benefits arose from.

The following can be taken:

• A charity lump sum death benefit.
• The payment of a lump sum which will be subject to a 55% tax charge.

For death after retirement, the type of income that the member was taking before death determines the type and amount of lump sum death benefit that can be paid to a dependant on death.

• Secured income in payment – the dependant can continue to receive pension payments until the end of any guarantee period and/or they can have a scheme pension (the only option available for a defined benefit scheme) or a lifetime annuity. The member may have also purchased a contingent dependant’s pension within their annuity and this will then continue to be paid for the life of the dependant.
• Drawdown income in payment (money purchase scheme only) – they can receive a dependant’s scheme pension, a lifetime annuity or a drawdown pension, (inclusive of a short-term annuity).
• Any lump sum death benefit will be subject to a 55% tax charge.

Defined benefit schemes can only offer a scheme pension. A scheme pension involves paying a pension for life out of the scheme assets or buying an annuity out of the scheme assets.

The value of the annual amount of pension promised by the scheme is multiplied by a standard valuation factor of 20:1. This factor includes an allowance for dependant’s benefits up to the level of the member’s pension at date of death and for annual increases of 5%. Any defined benefit scheme that provides better levels of dependants’ pensions or increases can apply to HMRC for a scheme specific valuation factor which can be higher than 20:1.

All tax-free lump sums are valued using a factor of 1:1 and are added to the above value.

Multiply the maximum annual income withdrawal entitlement of the member (not the annual income they are actually taking) by 25 when the first post A-Day benefit crystallisation event takes place.

If the member chooses to take drawdown income, the valuation basis is based on the actual fund value (market value of the assets) used to secure either:

• Income withdrawals
• Short-term annuities

If the member chooses to take a secured income, the valuation basis used depends on the option chosen when benefits are crystallised. These are:

• Lifetime annuity – the benefits will be valued on the basis of the fund value used to secure the lifetime annuity.
• Scheme pension – a scheme pension involves paying a pension for life out of the scheme assets or buying an annuity out of the scheme assets.

The value of the annual amount of scheme pension provided by the scheme is multiplied by a standard valuation factor of 20:1. This factor includes an allowance for dependants’ benefits up to the level of the member’s pension at date of death and for annual increases of 5%. Any scheme that provides better levels of dependant’s pensions or increases can apply to HMRC for a scheme specific valuation factor which can be higher than 20:1.

All tax-free lump sums are valued using a factor of 1:1 and are added to the above value.

Authorised payments are defined in the Finance Act 2004 and fall into authorised employer payments and authorised member payments.

Authorised employer payments include scheme surplus payments, compensation payments and authorised employer loans, among other things. Generally speaking if the payment does not fit the list of authorised payments it will be treated by HMRC as an unauthorised payment and taxed as such.

Authorised member payments include payment of pension benefits such as annuity provision, drawdown pensions, short-term annuities, tax-free cash, pension sharing benefits and pension death benefits.

From time to time, other types of payment may also be prescribed by regulations.

If a payment type does not fall into one of the categories described above, it will be treated as an unauthorised payment and will be taxed as such, unless it can be treated as a scheme administration member payment or a scheme administration employer payment

Scheme administration member payments are made for the purposes of the administration or management of the scheme. Typically, they are payments of salary to those engaged in administering the scheme but they can also include interest payments to the member in addition to a short service refund of contributions.

Scheme administration employer payments are payments to a sponsoring employer for the purposes of the administration or management of the scheme.

An unauthorised payment (both employer and employee) will be subject to a tax charge of 40% of the value.

In addition to this, if in the 12-month period from the date of the first unauthorised payment the total of all unauthorised payments exceed 25% of the total pension fund value, there will be an additional unauthorised payment surcharge. The amount of the surcharge is 15% of the original unauthorised payment taking the total unauthorised payment amounts up to 55%.

These charges are levied on the recipient of the unauthorised payment.

The scheme administrator is also taxed on the unauthorised payment by way of a scheme sanction charge. This is set at 40% but reduces to 15% if the unauthorised payment charges are paid to HMRC. Often if scheme rules permit, the scheme administrator will seek to withhold this payment from the member’s benefits.

A pension commencement lump sum needs to be paid within 12 months of it becoming available to the member when the member crystallises benefits under a scheme, or up to six months prior to this date. A pension commencement lump sum can only be paid when the member becomes entitled to pension benefits under the registered pension scheme, such as annuity or unsecured pension.

There is also the option of having a stand alone lump sum. This would only be available from a pre A-Day occupational scheme where the tax free cash at A-Day was equal to the A-Day fund value of that arrangement. A stand alone lump sum can only be paid where there has been no post A-Day accrual. The amount of the stand alone lump sum when paid will be the current value of the arrangement.