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The Finance Act 2004/5 contained proposals to simplify pension legislation. As of the 6th April 2006 (known as A day) these proposals have taken effect. Whether you are just starting your career as a Contractor or you are a Freelance Specialist about to retire, you need to know how these changes could affect the way that you plan for your Retirement.
'A' Day (Appointed day) brings with it sweeping and radical changes for Contractors. There will be far more flexibility as to how you access existing pension holdings and big changes to the rules surrounding ongoing investments, whether made via an employer contribution from a one-man limited company or personally from private funds.
Since this date the complex web of eight current pension regimes has been updated to just one set of tax rules for all types of pension, with an individual Lifetime Allowance (£1.5 million 2006/2007). This lifetime limit will rise by preset amounts for the next 5 years and looks likely to be increased beyond this date. This amount is so far in advance of what virtually all Freelancers would currently have built up in pensions that I have chosen to ignore the issues facing those who are close to this lifetime limit.
Contribution Levels after A Day
Given the substantial tax breaks associated with pension investment, a fundamental question that clients ask is how much they can invest in a given tax year. Unlike the previous restrictive rules that limited pension investment to a set percentage of salary, the new regime allows contractors to personally contribute 100% of salary. In addition the rules regarding funding a pension scheme direct from your limited company appear to allow a massive employer contribution of up to £215k pa irrespective of salary which would mean that, in effect, the only limiting factor on a Contractors investment would be the resources physically at your disposal.
Financial planners and investors greeted the promise of virtually unlimited employer contributions with great enthusiasm but as the mechanics of how the new rules will work in practice become clear, it now appears as if this new freedom could in reality be difficult to exploit. For a substantial 'employer' contribution to be allowable for tax relief, the final authorisation will potentially lay with the Local Inspector of Taxes, which implies that the new rules could trigger unwelcome interest from the taxman into a Contractors financial affairs. Clearly a situation where contributions are decided by the largesse of the local tax office could result in different allowable contributions depending on where an investors tax affairs are handled. Ironically the current restrictive, yet clear-cut percentage based rules may be giving way to a system that allows more scope to invest in theory but with less certainty in practice.
It appears that personal contributions, from a private bank account, will not attract the attention of the tax authorities to anything like the extent that a substantial employer contribution will. Compared to the age related maximum contribution (17.5% to 40% of salary) that currently applies, the new 100% limit will offer scope for many Freelancers to increase contributions.
On the negative side, the 'carry-back' rules, which currently allowed contributions to be classed as having been made in the previous tax year, were removed for most investors on 31st January 06. Freelancers also have lost the ability to make use of any higher salary from a previous tax year under the 'basis year' rule. This second rule had been widely exploited by investors who are now on tax efficiently low salaries yet could invest substantial amounts based on a previously inflated salary (perhaps a legacy of a spell as a permi or time spent within IR35).
Ongoing employer contributions could prove more problematical and it is still not clear how the new freedoms will be policed. It seems likely that contributions made within the old age related % basis could help ensure that any employer contribution will be viewed favourably now.
Full concurrency means that investors are able to pay into any array of plans, as opposed to the previous arrangements where many occupational pension holders and controlling directors were unable to enhance benefits with a personal/stakeholder pension. There is greater investment flexibility i.e. collective investments into property (although sadly not directly into residential bricks and mortar as originally planned when A day was first announced).
The new regime allows you to take 25% of all pension arrangements as a tax-free lump sum. For the first time this includes funds from Protected pension funds such as those that relate to contracting out of SERPS (the state earnings related pensions) and its replacement S2P (state second pension). You are also be able to take 25% of AVCs and FSAVCs (free standing additional voluntary contributions) as tax-free cash.
The new rules allow you to take non lump sum pension benefits in one of four ways:
From 6 April 2010, there will be an increase in the minimum age at which you can draw benefits from 50 to 55. Although there are certain exemptions to the age that pension benefits can be taken, there will be none for contractors in personal pensions (including stakeholder pensions), which currently permit retirement from age 50 onwards.
If the total value of all of your pension plans is £15,000 or less you may be able to take this all 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 calculate their total value. 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 could now take the whole fund as cash.
The previous regulations restricted life cover benefits but under pensions simplification the maximum death benefit that a contractor's family can receive is £1.5 million i.e. the Lifetime Allowance. Any excess paid as a cash lump sum over this amount will be subject to the 55% lifetime allowance charge payable by your family or beneficiaries. However if this excess is used to provide an annuity for your beneficiaries then this charge will not apply.
This added scope to fund your life insurance requirements via a pension will mean that contractors will be able to benefit from tax relief on Pension Term Assurance and this change of heart by the taxman is sparking a major review of existing life cover with the prospect of over 40% tax relief on contributions for some investors.
It is important to understand that, even at this late stage, some of the implementation of these new rules is not yet fully finalised and there may well be further changes to the application of the new legislation. However, it does seems fair to state that pension investment will allow far more freedom in future, with greater possibilities for tax savings, enabling contractors to build a better nest egg towards a prosperous retirement. At a time when the rest of the country looks to be sleep walking into a retirement funding abyss caused by longevity and low birth rate the message seems clear, that it its down to us as individuals to provide for our own futures as the state is increasingly unable to do so. At long last the authorities seem to be going some way to giving contractors the tools with which to provide for that future.
For further information, and to discuss your personal circumstances please complete our Pension Finder.
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