R04

Pensions and Retirement Planning

Essential Study Notes

R04 Essential Study Notes

2019-20
Modules:
1. Pension Planning in Context
2. Tax Treatment of Pension Contributions
3. Tax Treatment of Pension Benefits
4. Regulation and the Law
5. Defined Benefit (DB) Schemes
6. Money Purchase Schemes
7. Secured Pension Options
8. Flexible Income Options
9. State Benefits
10. Advice Considerations

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Essential Study Notes

Tax Treatment of Pension Contributions

In this module, we review the amount of tax-relievable contributions that can be made into a
UK registered pension scheme in a given tax year, the different contribution limitations in
place and the implications of exceeding those limitations.

We’ll also examine what happens at retirement where the value of an individual’s pension
rights exceeds the amount they are permitted to have under current legislation (i.e. where
their benefits exceed the lifetime allowance.)

Topics
Pension Contributions
Annual Allowance (AA)
Tapered Annual Allowance (TAA)
Carry Forward
Money Purchase Annual Allowance (MPAA)
Lifetime allowance (LTA)

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Essential Study Notes

Pension Contributions
Contributions can be paid by the member, a third party on behalf of the member or a
member’s employer or former employer.

Unlimited contributions can be made in any tax year. However, to qualify for individual
tax relief, the contribution must be made by a ‘relevant UK individual’ with ‘relevant
UK earnings’.

A relevant UK individual is eligible to receive tax relief on personal contributions up to

a gross value which is the greater of £3,600 p.a. or 100% of relevant UK earnings,
subject to limits imposed by the various annual allowance rules which we’ll look at
shortly.

For clarification, if a relevant UK individual has no relevant UK earnings, or has

relevant UK earnings up to £3,600 in a tax year, the individual can still contribute up
to £3,600 gross to pensions in the tax year and receive full tax relief. For example, a
65 year old with only state pension income (which is not UK relevant earnings) can
still contribute up to £3,600 in a tax year to a personal pension and receive full tax
relief. £3,600 is the gross amount; the net amount of contribution is £2,880.

Relevant UK individual
A relevant UK individual is someone under 75 who, in respect of a tax year, meets at
least one of the following criteria:

 has relevant UK earnings chargeable to income tax for that year;

 is UK resident during that year;
 is UK resident both when they became a member of the pension scheme
AND at some time during the five tax years immediately prior to the year in
which the contribution was made; or
 either they or their spouse/civil partner have earnings from an overseas
Crown employment subject to UK tax.

If the relevant UK individual criteria is not met, contributions can still be made but they will
not be eligible for tax relief.
Relevant UK earnings
Relevant UK earnings include:
 employment income: salary, wages, bonuses, overtime and commission;
 taxable profits for the self-employed;
 income arising from patent rights and treated as earned income; and
 earnings from an overseas Crown employment,
subject to UK tax.
 Earnings from furnished holiday lettings businesses
based in the EEA which satisfy certain criteria

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Essential Study Notes

NB. Dividends are NOT included in the definition of relevant UK earnings. Directors of
limited companies who choose to pay themselves a small salary and take large
dividends may therefore find themselves restricted in terms of the amount of pension
contributions they can pay.

Their two options are to increase their salary for a given tax year or contribute to the
scheme in their capacity as their own employer.

What this means is that if a pension contribution is made by an individual or a third-party

such as the individual’s spouse or parent for example, the amount of tax-relievable
pension contributions that can be made in respect of that individual in a tax year is
limited to the higher of the individual’s relevant UK earnings or £3,600.

However, if a contribution is made by the individual’s employer, the UK relevant earnings

rule goes out the window. The company claims Corporation Tax relief on the
contribution, and provided the gross contribution doesn’t exceed the individual’s Annual
Allowance plus available carry-forward, everything will be above board.

How tax relief is provided

Net pay method (of contributions/tax relief)
Net pay only applies to occupational pension schemes (but not group
personal/stakeholder pensions); this is a ‘gross from gross’ method: the employer
deducts gross contributions from gross pay before PAYE income tax and the
employee gets tax relief immediately.

Recently, former Pensions Minister and consumer advocate Ros Altman

highlighted that there are low-paid workers (i.e. with earnings below the Personal
Allowance) who get zero tax-relief on their pension contributions.

Take Mindy for example. She is a part-time cleaner who earns £10,000 per annum.
Over the year, her employer deducts £500 from her gross salary and pays this into
the company’s Occupational Pension Scheme (OPS) on her behalf. However,
Mindy is a non-taxpayer anyway, so the £500 does not get any tax relief. This is in
contrast to the Relief at Source method, where even though she’s a non-taxpayer,
she would’ve got 20% tax relief.

The argument is that while Mindy is a non-taxpayer now, she might not be in
retirement when you take into account her state pension plus her private pensions.
Is it fair for her to get zero tax relief on the way in, yet potentially pay 20% tax on
the way out?

In recent years, providers have sought to address the issue by amending their
systems to offer a Relief at Source option. This has included Smart Pension, NEST
and The People’s Pension. Meanwhile, NOW: Pensions has offered to top up the
pensions of non-taxpayers contributing via the net pay method. However, at the
time of writing, an industry-wide solution is still to be found.
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Relief at source
Individual contributions are made net (of basic rate tax (BRT)) from net pay. This is a
‘net from net’ method. Any additional higher or additional rate tax relief on
contributions is given by increasing the basic rate band (and higher rate band, if
applicable) by the amount of the gross contribution when calculating the amount of
total tax due on self-assessment.

This is best illustrated with an example:

- Brian is a higher-rate taxpayer.

- In 2019-20, he has UK relevant earnings of £60,000.
- He makes an £8,000 net contribution to his SIPP
- The SIPP provider claims back 20% (£2,000) on his behalf, which grosses
the total contribution up from £8,000 to £10,000. You can gross up by 20%
quickly by simply dividing the net amount by 0.8.
- Brian’s basic rate tax threshold increases by the amount of the gross
contribution, from £37,500 in 2019-20 to £47,500.
- This allows Brian to claim back a further 20% (£2,000) on the contribution.
This is done by self-assessment, so the amount doesn’t increase his pension
contribution anymore; it simply reduces the cost of the contribution.
- So in effect, the £10,000 contribution has only cost Brian £6,000.

I’ll be revisiting Brian and his pension contribution later.

Relief at source is the way in which tax relief is given through personal and
stakeholder pensions (including group schemes) and can be used for occupational
pension schemes.

Back to Mindy the cleaner for a second. If she were to be in a Relief at Source scheme such
as a GPP rather than her OPS which uses the net pay system, The £500 contribution would
only have cost her £400 because the pension scheme would’ve automatically claimed back
20% from HMRC and added it to the pension.

Relief on making a claim

One final method available is known as ‘relief on making a claim’. This method was used by
all retirement annuity contracts (RACs) prior to 6 April 2006 – contributions were made gross
and all tax relief reclaimed via self-assessment or adjustment to tax code. RAC providers
may continue with the relief on making a claim method or switch to relief at source.

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Impact on personal allowance of making pension contributions

One thing worth watching for is losing the personal allowance if adjusted net income
(income from all sources after deductions or pensions or charitable giving) goes over
£100,000. It's reduced by £1 for every £2; in 2019/20, the £12,500 personal allowance
will completely disappear when their adjusted net income reaches £125,000.

But making a pension contribution (and reducing the net adjustable income) you can
get the personal allowance back, meaning tax relief up to 60%.

The Child Benefit Tax Trap

In addition to the above £100,000 tax trap, there is also the High Income Child Benefit Tax
Charge introduced by the coalition government a number of years ago. Essentially, if one
person in a household has in excess of £50,000 net adjusted income for a tax year, and
either they or someone else in the household (generally their spouse) is claiming Child
Benefit, then an additional tax charge is levied on that individual which is payable by self-
assessment.
The charge has the effect of tapering away Child Benefit at the rate of 1% for every £100
earned which is in excess of £50,000. This means that a charge of 100% of the child benefit
is levied when you hit net adjusted income of £60,000. This is the maximum charge that can
be levied.
You can read more about this tax charge here: https://www.gov.uk/child-benefit-tax-charge

Tax relief for the self employed

The self-employed pay tax via self-assessment in three instalments – two payments on
account and one balancing payment. Higher/additional rate tax relief is accounted for in the
calculation of the balancing payment.

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Essential Study Notes

Salary Sacrifice (Salary Exchange)

Salary sacrifice is actually very simple. The employee agrees to change their contract to give
up part of their salary or a bonus and in exchange, the employer pays a contribution directly
into their pension. Both employee and employer pay reduced NIC, the savings can be
recycled into the pension scheme making the pension contribution larger at no extra cost to
either party.

HMRC has a number of rules that must be followed for the sacrifice to work:

 There must be a written agreement between both parties regarding the reduction in
salary
 The agreement must be in place before the salary is reduced
 The salary cannot be reduced below the national minimum wage
The agreement is usually irrevocable, although it may be possible to change the terms in the
event of a lifestyle change (e.g. marriage, divorce, redundancy / pregnancy of partner).

Example

Without salary sacrifice

 £36,000 a year employee, gross earnings.
 5% gross contribution into workplace pension scheme = £150 a month/£1,800 a
year gross pension contributions (£120 net contribution/monthly)

Example

With salary sacrifice

 salary sacrifice of £1,800
 save NI of £216 a year = £1,800 @ 12% (employee NIC rate)

That is how easy it is.

You can save the NIC on the pension contribution and take home more money, with the
same pension contribution being made; pay the same amount into pension each month
(£150 gross) and benefit from an increase in take home pay equal to the NI saving of £18
(£216/12) a month. No brainer.

Or, keep the same take home salary and add the savings directly into the pension, resulting
in more pension, more tax free cash, more tax-efficient savings return, more savings
protected from IHT.

Or, what could happen:

Example
With salary sacrifice and shared employer savings added
 employer yearly NI saving = £248.40 = £1,800 x13.8%
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Employer could share some of that £248.40 saving and make the pension savings even
bigger by putting all the savings into the pension pot.

Benefits of salary sacrifice

 Pay less income tax and National Insurance (NI) than before.
 Yet, take home pay will be the same or higher if they had previously been making
contributions
 If they had not, the reduction in pay will be less than the gross contribution now
payable
 NI savings can be paid into the pension
 Retirement savings will increase and a higher tax free lump sum figure may be
available
 Employees start to lose their personal tax allowance when their adjusted net
income goes over £100,000, but they can retain it by making personal
contributions to a pension scheme and get an effective rate of tax relief of 60%
 In a similar vein, a member might be able to avoid a high income child benefit tax
charge
 Entitlement to working tax credits may increase

Drawbacks of salary sacrifice

 Salary is reduced for all purposes, meaning benefits reliant on the amount of
salary paid, such as death-in-service, may be lower
 The employee may have a reduced capacity to borrow, although this may be less
of an issue now lenders have to judge on affordability rather than simply offering
a multiple of income
 Social security benefits may be reduced or lost

It should also be noted that salary sacrifice arrangements are high on HMRC’s legislative
agenda at present. Since the introduction of the TAA, salary sacrifice arrangements entered
into after 8 July 2015 have not been able to be used to reduce threshold income. This has
increased the scope for those utilising such arrangements to become subject to an annual
allowance tax charge.

HMRC has also introduced new rules from the start of the 2017/18 tax year forcing
employees to pay tax and national insurance on ‘optional remuneration agreements’, where
the employer provides benefits of a non-cash nature in lieu of remuneration. Thus far,
pension contributions have been exempted from the charge. However, this is subject to
further review.

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Essential Study Notes

Recycling of Pension Commencement Lump Sum (PCLS)

These rules impose tax charges where much larger pension contributions are made for an
individual as a result of a pre-planned drawing of the PCLS from a registered pension
scheme and recycling it back into a registered pension scheme to get more PCLS. The rules
apply when:

1. The PCLS in any twelve-month period is more than £7,500; and

2. The pension contribution is significantly (@30%) higher; and
3. The total of the increases in pension contributions exceeds 30% of the PCLS; and
4. The contribution was made by the individual or someone else on their behalf (employer);
and
5. Recycling was pre-planned.
HMRC guidance makes it clear that unplanned recycling won't be caught by the rules.

Any PCLS that's caught by recycling rules will be treated as an unauthorised payment and
be subject to unauthorised payment tax charges.

Examples

Lynn’s PCLS was £5,000. She recycles all of it into a stakeholder pension.
 Because the PCLS was less than £7,500 this will not be treated as an unauthorised
payment

Caroline’s PCLS was £20,000. She currently contributes £100 a month into a
workplace pension. She recycles £10,000 on her PCLS into her workplace pension.
 The PCLS is in excess of £7,500. Her usual annual contribution is £1,200. The
recycled amount is significantly higher (over 30%) than this and exceeds 30% of
the original PCLS. This will therefore be treated as an unauthorised payment.

Employer contributions
As for the employer, you can take it that pension contributions (for both individuals
and schemes) will normally pass the wholly and exclusively test and qualify for tax
relief, as the starting point for the HMRC – it will be rare that it doesn’t (except in
cases of abuse).

For larger contributions, tax relief on employer contributions to a particular scheme will be
spread if, the employer contributions:

1. Exceed 210% of the contributions they made to the scheme in the previous
chargeable period, and
2. Amount of the relevant excess is £500,000 or more, where the relevant excess
is any amount paid over and above 110% of the contributions in the previous
chargeable period.

3. Tax relief is spread over 2 years (£500k-£1m excess), 3 years (£1-2m) or 4

years (£2m+).
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Example
Last period: pension contribution of
£300,000
This period: pension contributions £1m

? What’s the tax relief in the next period?

You can see there was a large increase in contributions, but how much have they
increased and would it mean spreading in this example?
Step 1: Quantify both the increase and the relevant excess:
1. Increase: the payments in this period were more than 210% of the previous
year's contributions: 210% x £300,000 = £630,000, so £1m is greater than 210%
increase. This rule is satisfied, so progress to the next part

2. Calculate the relevant excess: = [£1m - (£300,000 x 110% = £330,000)] =

£670,000

Here the ‘relevant excess’ is greater than £500,000 (it is £670,000) and therefore
spreading of ER tax relief will happen. This means that not all the larger ER
contribution will get immediate tax relief in this period (the HMRC prefers to spread
the tax relief of these large pension contributions).

Step 2: How many years spreading?

The relevant excess is over £500,000 and tax relief is spread over two years.
Remember the figures: the tax relief is spread over 2 years (£500k-£1m excess), 3
years (£1-2m) or 4 years (£2m+)

Step 3: How are the contributions spread?

The relevant excess is spread over two years (in the above example) in this way:

£670,000 /2 = £335,000 spread over 2 years, which means the contribution will be
split for tax relief purposes: £335,000 on each of this period and the next period.
The tax relief is spread over 2 years:

a) This period the total tax relief on contributions being (£330,000 + £335,000); this
is 110% of previous year plus 50% (spread over 2 years) of the relevant excess
(which was
£670,000).
b) The next period, £335,000 is eligible for tax relief, in addition to anything
else in that period.

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Annual Allowance (AA)

Overview

There is a limit on the tax relief available for contributions (made by, or for a
member) to UK registered pension schemes per tax year.

If the total pension input amount is more than the annual allowance (AA), there could
be an AA tax charge which, in effect, enables HMRC to claw back the relief given.

 The AA was £50,000 (gross) for tax years 2011/12 - 2013/14.

 Since tax year 2014/15, the AA is reduced to £40,000 (gross total

contribution).

 Since tax year 2016/17 the AA is tapered down to a floor of £10,000 where the
member has adjusted income in excess of £150,000, (Tapered Annual Allowance
(TAA) – more on this later).

 Those who have flexibly accessed their pension benefits are subject to the Money
Purchase Annual Allowance (MPAA) of £4,000. More on this later.

Note that for 2015/16 the tax year was split into pre and post alignment mini-tax
years on account of the changes in pension rules that came in in that tax year.

 6 April 2015 – 8 July 2015 = pre-alignment tax year

o Maximum AA was £80,000
 9 July 2015 – 5 April 2016 = post alignment tax year
o Maximum AA was the lesser of
 £40,000 or
£80,000 less actual pension input in pre-alignment year
Technically speaking, the AA for the post-alignment tax-year is nil. However, the
lower of £40,000 or £80,000 less pension input in the pre-alignment tax year can be
carried forward into the post-alignment tax year.

AA test
What's tested against the AA for a particular tax year is the total pension input
amount (PIA); this is the sum of all pension input amounts made within pension input
periods – which for 2019/20 are now all fully-aligned with the tax year (i.e. 6 April 19 –
5 April 20).

The calculation of the pension input amount depends on the type of scheme:

 Money purchase schemes - it's the total of relievable pension contributions

made during the pension input period by the member personally and/or on their
behalf by their employer or any third party - regardless of whether tax relief has
been given on those contributions. It does not include any contributions paid
after the member’s 75th birthday or increases in fund value due to investment
income or capital gains.
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 Defined benefits and cash balance schemes – for active members it's the
value of the increase in pension benefits from the start of the period to the end
of the PIP. The increase (if any) is the value of the member's rights under the
scheme at the end of the pension input period (known as the closing
value/end) less the value of those at the beginning of the pension input period
(the opening value/start).

 The opening and closing values for pension rights are calculated using
a factor of x16 for defined benefit pension savings income increase in
tax year 2019/20

 If the scheme provides separate lump sum rights in addition to the pension
(rather than by commuting part of the pension) then the lump sum should
be added as calculated and added as a single amount (not x16 the LS).

 The opening value of the member's defined benefits rights is revalued in line
with the 12 month increase in the Consumer Price Index (CPI). This CPI
figure is defined in the previous September before the tax year in which the
input period ends (and the AA calculation is based on). The figure for the
2019/20 tax year is 2.4% (which is the CPI for September 2018).

Example

Jim, a member of a defined benefit pension scheme providing (for each year):
 a pension of 1/80th of pensionable salary; plus
 a separate lump sum of 3/80ths of pensionable salary

He completed 20 years pensionable service and his pensionable salary increased

from
£60,000 to £66,000.

His pension input amount for the 2019/20 tax year is calculated as follows:

Start of input End of input

period period
Pensionable service completed (years) 19 20
Pensionable salary £60,000 £66,000
Accrued pension £14,250 £16,500
Accrued pension multiplied by a factor of 16 £228,000 £264,000
Tax free lump sum £42,750 £49,500
Opening value (£228,000 + £42,750) revalued by CPI
£277,248.00
(Sept 2018, 2.4%); £270,750 x 2.4% = £6,498
Closing value (£264,000 + £49,500) £313,500
Value for testing against the annual allowance £36,252
(£313,500 - £277,248.00)

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Usually deferred members are not deemed to have pension input.

Contributions and accrual in the tax year in which the member dies or in the tax
year where benefits are taken due to severe ill-health (less than 12 months to live)
are excluded from total PIA.

Where total PIA is more than the AA, the member will normally face a tax charge
on the excess (there are some exemptions), but it's possible, in certain
circumstances, to carry forward unused annual allowance from the previous three
tax years to offset this charge as we’ll see shortly.

The tax charge is at their highest marginal rate (i.e. 20% basic rate tax payers,
40% higher rate tax payers and 45% additional rate tax payers). This has the effect
of clawing back the tax relief given in the first place.

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