From 6 April this year, the Government's much-heralded stakeholder pension plan comes into being. So...
From 6 April this year, the Government's much-heralded stakeholder pension plan comes into being. Some 30 months after the initial draft proposals were issued in December 1998 and after much consultation on the various areas of consideration, the final rules are now in place. Providers are registering their products as stakeholder plans, ready to accept contributions from 6 April.
However, what is not so widely known is that stakeholder is not just a new type of pension plan, it is actually a whole new pension taxation regime. While the more obvious implications are on stakeholder, the wider reach will also cover all personal pension plans (existing or new) and may also affect occupational money purchase schemes (although this last category can choose to remain under current legislation or come under the new rules).
The main effect of the new tax regime for all existing and future personal pension plans is on the amount and format in which contributions can be paid. From 6 April onwards, all individuals not in an occupational pension scheme will be able to contribute £3,600 a year gross to either a stakeholder or personal pension plan, irrespective of earnings. For the first time, this will allow individuals without earned income (housewives, carers or children, for example) to contribute to a pension, either directly or have the contributions paid by a third party.
In addition, the Government has taken the opportunity to simplify the earnings basis on which contributions are calculated. From the end of this tax year, individuals will no longer be able to use current carry forward legislation for personal pension plans. This concept allowed individuals to make large contributions in one tax year (and obtain full tax relief at their appropriate tax rate) by utilising unused contribution allowances from previous years.
Maximum contributions to personal pension plans are restricted to a percentage of net relevant earnings each year. If this maximum is not reached, it is possible under current legislation to carry forward any unused contribution relief from the previous six tax years into the current tax year.
As you receive tax relief at your highest tax rate, it is clearly in your best interests to take advantage of this legislation if you can. For example, if you are a basic rate taxpayer, you will benefit from tax relief at 22%. A higher-rate taxpayer will enjoy 40% tax relief.
Carry forward is particularly important for those self-employed individuals with fluctuating income from year to year as it allows available income in the better years to make up for unused contributions in the poorer ones.
Another example of maximising the current rules would be for individuals who have recently become higher rate taxpayers after being basic rate. In these circumstances, they would be able to sweep up previously unused allowances (which would have been restricted to the prevailing tax relief at 22%) and benefit from the higher rate tax relief of 40%. For unused allowances of £5,000 being carried forward, this additional relief could be worth up to an extra £900 (the difference between basic and higher rates of tax on this contribution amount).
To illustrate how carry forward works in practice, let us look at an example. John Miller was born on 6 January 1961 and is currently aged 40. In the 2000/01 tax year, he decides he would like to make a lump sum contribution of £10,000 into his existing personal pension plan. His earnings and pension contribution history is summarised in the Table 1.
To make the proposed contribution, John would need unused allowances totalling £5,400 - the difference between his maximum for this year of £4,600 and the total proposed contribution. From the right-hand column in Table 1, it is clear that he has sufficient unused allowances to justify this contribution.
The earliest allowances are carried forward first, so the £5,400 would be allocated between the 1994/95 to 1997/98 tax years, leaving £560 of unused allowances in the 1997/98 tax year and £1,700 in the 1999/00 tax year. Indeed, John could choose to increase the single contribution that he wishes to pay by £2,260 and use up all his unused allowances.
Although obviously not everyone will be able to take advantage of this rule before it disappears, we would recommend all personal pension holders review their options and consider all available means to top it up. Remember though, that contributions to take advantage of carry forward must be paid by 5 April 2001. From 6 April onwards, the new system will differ significantly from this.
Instead of having a maximum contribution each year, and then being able to make this contribution at a later date (perhaps when profits are better or when other money becomes available), the new system will look at earnings each year.
Anyone intending to contribute more than £3,600 a year would be limited to the current personal pension contribution limits (varying between 17.5% and 40% of earnings, depending on age) and would also have to produce evidence of earnings. Once provided, these earnings can be the basis for contributions in the year the plan is started, and for the following five years.
If earnings increased, and the individual wished to contribute more to a pension than at present, then he or she could provide fresh evidence of the increased earnings, and increase contributions accordingly. This new earnings figure would then be the benchmark for the next five years, unless superceded by further increased evidence.
To see how this would work in practice, let us consider John's twin sister, Jane. She is self-employed, in a business with fluctuating earnings. In Table 2 are details of her earnings over the past seven years, along with the maximum she could have contributed under the old and new systems. Note that this is purely for comparative purposes because each tax system will apply separately and not simultaneously.
As can be seen in Table 2, the new system would be better for Jane because her earnings have fluctuated dramatically, and her highest earnings can be used as a base for the appropriate tax year and the following five tax years. However, this is only true if she makes the maximum contribution in each tax year. If we refer back to John, he would be disadvantaged by the new system, because he had paid only a minimal contribution in most tax years, instead preferring to maximise unused allowances in one year.
What should happen under the new system is that individuals have a more hands-on approach to pensions, addressing the issue of contribution amounts on an annual basis (and perhaps more frequently) instead of the current method of permitting allowances to accrue for several years. This should lead to more disciplined pension planning and a financially healthier retirement.
Gary King is pensions manager at Save & Invest
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