Even those who don’t yet earn £150,000 a year should review their options to avoid punitive tax when they retire, writes Scott Moore
RETIREMENT savers at risk of being hit by hefty tax penalties after new pension allowances take effect next year are running out of time to take action.
Changes to the amount that can be paid into pensions annually and over a lifetime could impact on people with relatively modest pension pots now but with plenty of time to build them up before retirement.
The annual allowance for pension contributions will be cut for those earning more than £150,000. At the same time, the lifetime allowance for pensions will be reduced from £1.25 million to £1m, in a move that Hargreaves Lansdown estimates could catch out some 460,000 savers.
While these changes will clearly be more of an issue for higher earners, the reduction in the lifetime allowance may potentially impact savers with reasonably sized funds who still have many years until retirement. Ultimately, higher living costs, an increased state pension age and the fact that people are living longer means that 40-year-olds today could face hardship in retirement if they don’t take the necessary steps now.
A cut in the annual allowance could cause issues for people who start to earn a significant amount near the end of their careers, such as partners or directors of companies. Currently it is common practice that people may look to maximise pension contributions in the later stages of their careers to boost their retirement fund conscious that they are nearing retirement age. But, from April 2016, that strategy will become much more difficult as tax relief on contributions will be restricted further.
The current allowance of £40,000 a year will be reduced by £1 for every £2 of income received above £150,000. Every individual will retain an allowance of £10,000 regardless of their income. In practical terms, this means anyone with income of £210,000 and above will have a reduced annual allowance of £10,000 as opposed to the full £40,000.
So what can you do if you’re nearing retirement and face such a dilemma?
You could consider maximising contributions, if you can afford to, before the changes are implemented. By carrying forward unused allowances from the previous three years, larger contributions can be made with full tax relief before the changes are implemented, adding a substantial amount to your pension fund now. When making large contributions, however, you should also consider the second key change from April 2016 – the reduction of the lifetime allowance. This is the amount that a pension fund can grow to before there is a punitive tax charge on the excess.
Your pension can be made up of funds in different types of scheme – either a “money purchase” (defined contribution) scheme or a “final salary” (defined benefit) scheme. If someone has had several jobs they may well have accumulated a number of retirement plans across both types of schemes and may be totally unaware of the deemed value of their overall pot and, in turn, exactly how close they are to reaching the limit of £1m.
Money purchase pension schemes are fairly straightforward as the total amount available at retirement is the actual fund value of the pension pot. On the other hand, a final salary scheme pension pot is calculated using a formula based on length of service and the salary level at retirement. The deemed fund value is then calculated by multiplying the pension by a factor of 20 and added to any other pension funds accumulated.
It is very important to be aware of not only how much has been contributed annually to a pension, but also what the final pension pot will translate to. The first thought of many is that the reduction of the allowance to £1m will affect very few people. However, a 40-year-old who currently has £500,000 in their pension fund and another 25 years of annual contributions to make could easily reach the allowance limit. Individuals who have accrued benefits in a final salary scheme over many years, such as doctors, dentists and civil servants, may also be impacted.
Similarly, many will expect the life allowance to increase over time. Although there is a commitment for the government to increase this in the next few years, we have seen a reduction over the past few years from a high point of £1.8m, therefore it is very difficult to predict what it is likely to be once an individual actually retires. Exceeding the lifetime pension allowance could lead to a tax levy of 55 per cent on any withdrawals in excess of the £1m. Therefore it makes sense to acknowledge this change and again look at alternative ways to save, if appropriate.
For example, maximising Isa contributions is very tax-effective. Whilst no tax relief is available on contributions, capital is easily accessible, with no tax to pay on gains or income taken.
The way we save and how we plan for our later years is changing dramatically. The latest reforms are widely expected to be merely the starting point for a raft of potentially radical changes that are likely to impact on every one of us, regardless of the size of our individual pension funds.
What the reforms should not do is put you off exploring how you save for retirement. Talk to a financial adviser to see what works best for you.
• Scott Moore is senior manager in Grant Thornton’s Wealth Advisory team in Scotland