This week sees the end of the carry forward unused relief scheme. All is not lost however, for those pension holders who fail to take advantage of it before the 31 January deadline
The new rules for carrying back personal pension contributions into the previous tax year for relief changed from 6 April 2001. At the same time, carry forward of unused relief was abolished and replaced by the new basis year concept.
However, there is currently a very short-lived opportunity to use both regimes to advantage if you act by 31 January.
The new carry back rules mean that you can make a personal pension contribution before Thursday and elect for it to be carried back to tax year 2000/1. You will then be in a tax year that is in the old carry forward regime and can therefore carry forward unused relief from the previous six tax years.
This will mean different advantages to different people but could give rise to reclaiming a large amount of income tax. Taking an extreme example, consider a man now aged 65 who earned above the earnings cap for the last seven years and made no pension contributions (and was not in an occupational pension scheme). He could possibly contribute £224,760 (if he had sufficient net relevant earnings to set it against in 2000/1) and claim back up to £89,904 at 40% tax.
For most people, the scope may be less but the principle is still valid. If the amount that can be contributed is within the amount of relevant earnings taxable at higher rate in 2000/1, you can get back 40 pence in the pound.
This might be of particular relevance to people retiring now or in the near future. Take a more modest example of the same man in the previous example. Suppose he retires this year and has £35,000 capital to invest for income. On the face of it he might get around 4% gross from a building society and after basic rate income tax get £1092 per annum net income. This will be welcome but not enough to be significant. If he dies, his heirs would get the £35,000, or £21,000 if inheritance tax is payable.
If the same man has scope to carry back and carry forward, he could take a short-term loan or use other capital and make a gross personal pension contribution of £100,000 (actually paying £78,000 net of basic rate tax). He could then reclaim higher rate tax of £18,000 and almost immediately take the 25% tax-free cash of £25,000. He would then have £43,000 back, and have actually invested only £35,000 to have £75,000 remaining in a personal pension.
Depending on how the money was invested before and after reinvesting in the pension, there would be administrative costs and they could be higher in the pension. If these costs represent 5% of the value of the investments made, then the pension fund might drop to £71,250 but this still more than double the original investment.
However, if he uses a self invested personal pension (Sipp), he will have wide investment scope and may be able to invest in the same way as he did before putting the money into the pension plan.
If he then opted for drawdown of near the maximum, he might take back £6,000 per annum, which after basic rate tax, would be £4,680 per annum (but this could erode the fund value if the investment performance was insufficient).
To keep the comparison consistent, he might take only the 4% interest as drawdown income but this would be £3,000 per annum gross or £2,340 net of basic tax.
Of course, the £75,000 in his pension is not entirely comparable with the £35,000 capital. Once inside the pension, the money is not accessible. If he dies in drawdown before age 75, his heirs would get the current fund value less 35% in tax. If this were the original £75,000, then they would get £48,750 after tax, which is a significant improvement and usually free of inheritance tax.
However, the fund value could be less (or more) than £75,000 depending on the rate of drawdown and charges compared with the investment return.
By age 75 (under current rules) an annuity must be purchased. This means the capital is then lost on death, apart from a dependant's pension or guaranteed period if so arranged. However, a maximum 10-year guarantee at 75 returns about 10% per annum gross annuity. If the original £75,000 fund remains to purchase the annuity then the guaranteed annuity is £7,500 per annum gross or £5,850 after basic rate income tax.
Our man could then decide to use his £3,000 annual inheritance tax exemption and gift this amount to his heirs and retain the balance of £2,850 per annum as income.
If he dies after age 85, he will have given at least £30,000 to his heirs tax free over ten years and can continue for the rest of his life. If he dies between 75 and 85, his heirs get the remaining installments of the annuity for what is left of the original ten years, in addition to the annual gifts received up to the year of death.
This may sound rather complicated but it is all quite straightforward to arrange. It could make substantial improvements to a client's income for the rest of their life and what they leave to their heirs on death.
After 31 January 2002 this chance is lost but the new regime applies to any future personal pension contribution you may wish to make. While carry forward of unused past relief is then not possible, a different advantage replaces it whereby you can continue to make pension contributions into the future for up to five years based on the starting year's earnings, even if you have no further relevant earnings.
Furthermore, if eligible, you can make annual contributions up to the limit of £3,600 each year regardless of age (up to 75) and even if you have no relevant income at all.
It is for each individual to assess what advantages there are in using the last opportunity to carry forward unused relief in this way. Much will depend on particular circumstances such as past earnings levels and income tax rates reclaimable. It will also hinge on individual objectives such as raising net spendable income in retirement and improving the eventual net benefit to your heirs on death.
Whatever, it is well worth exploring but people will need to move quickly and it may be sensible to take professional advice for guidance through the details.
New carry back rules could give rise to reclaiming a large amount of income tax.
The usefulness of this loophole will depend on past earnings levels and income tax rates reclaimable.
Professional advice is necessary to guide clients through this opportunity.
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