These tax changes to pensions

Contrary to the widespread belief that only City fat cats on massive bonuses need worry, savers being targeted by the taxman range from members of public sector pension schemes…

Is it the public sector schemes, at least the top end of them, which will be hit hardest?

I\’ll probably garble this but, so, we\’ve got one major change which will hit them.

So there\’s this maximum pension limit, the maximum value of a pension you can have while still getting tax relief. £1.5, 1.8 million, something like that.

When you\’re making contributions to a fund this is easy enough to value. But what about those public sector pensions which aren\’t so funded, which are final salary ones?

It\’s been assumed so far that you take the annual pension and multiply it by 10 to give what the value of the fund is. This is to now go up to 16, maybe even 20.

Seems fair enough really, given that life expectancy at pension age is between 15 and 20 years.

So, fat cat civil servant, on £100k a year pension (not that there are all that many of those but….), under the old rules was estimated to have a fund of £1 million. Under the new, £2 million and he gets to pay tax on that pension….when it\’s earned, not just when it\’s paid out to him.

Have I got that right?

And if I have, is that really what this is all about? Taxing back some part of those overly generous pensions granted to parts of the public services without actually breaching the contracts under which such pensions have been granted?

9 comments on “These tax changes to pensions

  1. “Taxing back some part of those overly generous pensions granted to parts of the public services without actually breaching the contracts under which such pensions have been granted?”

    Never thought of that. As Bob Peck said to the velociraptor, “clever girl”.

  2. He would only be taxed on the bit of it that’s over the maximum (which is going to be cut to £1.5 million, so he will be taxed now, while he’s working, on £500,000 (the £2m value minus the £1.5m limit). But yes, that looks about right.

    But they’ll be hit in another way too. There isn’t just a limit on the capital value of the pension (the £1.5 million), there’s also a limit on the annual increase in value, which is going to be £50,000.

    So if our public sector employee is on a scheme that promises him a pension of 1/60th of his final salary for each year that he is so employed, say he’s been there for 20 years, was earning £60,000 and gets a promotion that takes his pay up to £75,000. Lets assume they go for 20 as the multiple (keeps the maths easier):

    Year 1, his pension if he retired straight away would be (20/60) x £60,000 = £20,000. The capital value of that accrued pension right, using the 20 multiplier, is therefore £20,000 x 20 = £400,000

    Year 2, he’s worked an extra year and his salary has gone up, both of which increase the potential pension, so his accrued pension rights would be worth (21/60) x £75,000 x 20 = £525,000

    So the value of his accrued pension has increased by £125,000 in one year. That’s more than the £50,000 annual contribution limit, so he’ll be taxed on £125,000 – £50,000 = £75,000. Since he’s paying 40% tax, that’s £30,000 tax.

    That’s what they’re bleating about.

    But actually he probably won’t have to pay that much tax, for two reasons:

    1) He’s allowed inflation on last year’s value (just as a funded scheme isn’t taxed on its investment returns). If inflation is 3%, then 3% x £400,000 = £12,000 of that increase in value would be tax free. So he’s only taxed on £63,000 rather than £75,000.

    2) If you don’t use your £50,000 annual limit, you will be allowed to carry the remainder forward for future years (from memory for 3 years). Assuming he didn’t get an above-inflation pay rise in the previous 3 years, his annual increase would have just been because he’d clocked up an extra year’s employment. So the previous year the value of his pension would have been (19/60) x £60,000 x 20 = £380,000. From that to £400,000 is only an increase of £20,000, so he would have had £30,000 of his £50,000 annual limit left to carry forward. Three years of that would be more than enough to cover him.

    So actually they are only going to taxed if they either have huge pensions (which, as you say, isn’t many of them) or they regularly get pay rises that are far above inflation.

  3. Richard: My understanding is that they use the 20x factor for the lifetime allowance calculations (which came into being in 2006, and are nothing new – all they’re doing now is taking it back to the 2006 level of £1.5m) but that they use a 10x factor for the annual allowance calculation. At least they always did use a 10x factor, and I’ve seen nothing so far to say that that’s changing.

  4. Just keep an eye on early retirement/voluntary severance/redundancy before 06.04.2011. Presumably it’ll become more attractive.

  5. RA – nope; I’ve just looked it up, and they are going to increase the multiplier for the annual increase as well as the lifetime allowance. It wouldn’t make sense otherwise, because in both cases you’re estimating the capital value of the future pension.

    Although it seems HMRC’s current assumption is that the factor (for both purposes) will be 16 rather than 20.

    See here:
    http://www.hmrc.gov.uk/pensionschemes/annual-allowance/pension-input.htm#2

  6. dearime – civil servants resigning? That would be an added benefit for the public finances!

    (Provided it’s early retirement on standard terms, rather than enhanced or redundancy).

  7. They’ll be using 16 for the LTA as well? That means that in real terms, for people with a DB benefit the allowance is going up, not down.

    Current allowance is £1.8m and the factor is 20, meaning that a pension of £90k is at the limit and anything over that is taxed.

    New allowance is £1.5m and the factor is 16, then a pension of £93,750 is at the limit and anything over that will be taxed…

  8. “There isn’t just a limit on the capital value of the pension”

    For DC schemes, the lifetime limit is the amount contributed, not the actual valuation of the fund after investments have gone up/down, yes?

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