Background
Pensions tax legislation
4.The legislation relating to UK registered pension schemes is set out in Part 4 of Finance Act 2004 and came into force on 6 April 2006 (commonly known as A-day). Legislation relating to the taxation of pension income is set out in Part 9 of the Income Tax (Earnings and Pensions) Act 2003.
5.The UK’s existing system of pensions tax relief is typically described as Exempt, Exempt, Taxed (E, E, T), where each of the three letters corresponds to a phase in the lifecycle of pension savings. The first relates to the contributions, the second to the investment return and the third to the benefit payout:
(E): tax relief is available on individual and employer contributions to a pension scheme. The employer contribution is not treated as a taxable benefit-in-kind for the employee. This means that contributions to a pension are not subject to income tax or to corporation tax. Furthermore, employer contributions do not give rise to a national insurance contribution (NICs) liability. In relation to individual contributions, tax relief is available at the individual’s marginal rate, meaning relief is worth more to individuals who pay a higher marginal rate of income tax. Relief is available on contributions worth up to 100% of individuals’ earned income or £3,600 if higher. But if annual and/or lifetime limits are exceeded, there are tax charges on the excess.
(E): investment growth within pension schemes is not subject to income or capital gains tax.
(T): when benefits are drawn, individuals are able to take a tax-free lump sum of up to 25% of the value of their benefits. The remaining pension rights are used to deliver an income usually payable for life, which is taxed like any other pension income. Pensions paid from tax-registered pension schemes are not subject to NICs.
6.This tax relief is given so that the funds are used to provide benefits later in life for the member and their dependants. The tax rules therefore set out what payments a registered pension scheme is authorised to make to or in respect of a person who is or has been a member of the pension scheme. That is, payments that meet the purpose for which tax relief has been given. These payments are known as authorised member payments and are set out in Finance Act 2004.
Authorised member payments
7.Authorised member payments include pensions, lump sums and death benefits permitted by Finance Act 2004 as well as transfers to another registered pension scheme or to certain overseas pension schemes.
8.Pension schemes are made up of one or more arrangements. Each arrangement is defined by the type of benefits that will be paid, and is either a defined benefit arrangement (that is where the benefit to be provided can be expressed in a value per year, for example as part of a final salary scheme) or a money purchase arrangement where the benefits to be provided are determined by the size of the individual’s pension fund.
9.The only types of pension that can be paid from money purchase arrangements are scheme pensions, lifetime annuities or drawdown pensions. Scheme pensions and lifetime annuities must be payable for life and cannot decrease except in limited permitted circumstances.
10.A drawdown pension can either be income withdrawal or a short-term annuity. Individuals who want to go into drawdown must first designate some, or all, of their pension fund as available for drawdown, to what is known as a member’s drawdown pension fund. The funds then remain invested until they are paid as income to the member.
11.Normally the amount of drawdown pension the individual can have in a year is limited. This is called capped drawdown. Under capped drawdown, the amount paid from the member’s drawdown pension fund can vary each year. However the maximum that can be paid is 150% of the amount of an equivalent single life annuity that the member’s drawdown pension fund could buy (the basis amount).(1) That way the member’s drawdown pension fund should not be used up and as such the capped drawdown pension can be paid for life.
12.The only time an individual can take more than this maximum from their drawdown fund is where they meet the conditions to take flexible drawdown. To qualify they must have a guaranteed pension income of at least £12,000(2) a year. Where an individual meets the conditions, they can take as much of their member’s drawdown pension fund as they wish in any year.
13.Where an individual first becomes entitled to a pension, they can normally take up to 25% of their pension fund tax free. All pensions, whether scheme pensions, annuities or drawdown are taxable in the hands of the individual as pension income at their marginal rate.
14.Similar rules apply to dependants where pension funds have been passed to them on the death of the member. These funds can be taken in the form of a dependants’ scheme pension, a dependants’ annuity or a dependants’ drawdown pension. If the dependant wants to take funds as a dependants’ drawdown pension, they must first designate those funds to a dependant’s drawdown pension fund. A tax-free lump sum cannot be paid in connection with a dependants’ pension.
15.In certain circumstances, a lump sum death benefit can be paid on the death of a member. For money purchase arrangements, where pension funds have not yet been taken or designated into drawdown, then the only lump sum that can be paid is uncrystallised funds lump sum death benefit. Where the member was in receipt of an annuity where the contract provided for a lump sum to be paid on their death, then an annuity protection lump sum death benefit can be paid. Where the member was in receipt of a drawdown pension, a drawdown pension fund lump sum death benefit can be paid or, where there are no dependants, a charity lump sum death benefit can be paid. These lump sum death benefits are subject to a 55% tax charge payable by the scheme administrator, except a charity lump sum death benefit which is paid tax free, and except where the member dies before age 75 in which event the uncrystallised funds lump sum death benefit can be paid tax-free.
16.The only circumstances apart from flexible drawdown where an individual can normally take all of their pension pot as a single one-off payment is where their total pension savings in all funds are less than £30,000(3) (the trivial commutation limit), or in certain circumstances where the value of a small pension pot is less than £10,000(4). To qualify for these payments, the individual must have reached age 60.
17.Normally under these rules 25% of the payment can be taken tax-free with the remaining 75% taxed as pension income at the individual’s marginal rate.
18.Dependants’ benefits can also be paid to a dependant as a trivial commutation lump sum death benefit. The maximum that can be paid as a trivial commutation lump sum death benefit is £18,000, but the whole lump sum will be taxable at that dependant’s marginal rate.
19.Where a payment is made to or in respect of a member that is not an authorised member payment, this is known as an unauthorised payment. Where an unauthorised payment is made, certain tax charges apply which can, depending on the circumstances, total up to 70%. These charges are intended to recover the tax relief previously given, as a payment has been made which doesn’t meet the purpose for which the tax relief was given.
Limits on tax relief
20.Since A-day, there have been no limits on the amount of pension savings an individual can have, but there are limits on the amount of tax relief that is available: these are the lifetime allowance and the annual allowance.
21.The lifetime allowance is the maximum amount of pension and/or lump sum that an individual can take from their pension schemes that benefits from tax relief. There is no limit on the amount of benefits that a pension scheme can pay an individual. The standard lifetime allowance is £1.25m for tax years 2014-15 onwards. Where the value of pension benefits taken (known as benefit crystallisation events or BCE) exceeds the lifetime allowance, the lifetime allowance charge applies to the excess. The rate of the lifetime allowance charge will depend on how the individual takes their benefits.
Any amount over the lifetime allowance taken as a lump sum is taxable at 55%.
Any amount over the lifetime allowance taken as a pension is taxable at 25%. The pension will also be taxable at the recipient’s marginal rate.
22.There is also a limit on the amount of annual pension savings that benefits from tax relief. This is the annual allowance. The annual allowance is £40,000 for tax year 2014-15 onwards. Any unused annual allowance in respect of an individual can be carried forward from the three previous tax years and added to the £40,000, to make the individual’s annual allowance for that tax year.
23.How pension savings are measured against the annual allowance depends on the type of arrangement. The pension savings for each arrangement are known as the pension input amount and the sum of all these amounts in respect of an individual is the total pension input amount. If an individual’s total pension input amount is more than their annual allowance they will pay a tax charge on the excess over their annual allowance. This tax charge is called the annual allowance charge and is charged at the individual’s marginal rate.
24.For most money purchase arrangements, the pension input amount is the total contributions made by the individual or anyone else on their behalf, including any made by any employer. The exception to this is where the arrangement is a cash balance arrangement where the pension input amount is the increase in the promised fund for the individual. For a cash balance arrangement the pension input amount could, for example, be the amount an employer has promised to provide for an employee, but without making a contribution to fulfil that promise until many years later.
25.However, in defined benefit arrangements, individuals accrue a right to an amount of annual pension from pension age based on a variety of factors, for example years of service or salary. To treat the two in a comparable way, a deemed notional contributions value is applied to the increase in value of pension rights between the start of the year and the end of the year. For defined benefit arrangements, the pension input amount is therefore calculated by multiplying the increase in their expected pension over the course of the year by a factor of 16. This broadly means that an increase in annual pension benefit of £1,000 would be deemed to reflect a contribution of £16,000.
26.Where an individual has a hybrid arrangement, as defined in section 152 Finance Act 2004, it is more difficult to calculate a comparable contribution value because the type of benefits provided are not decided until they are taken. In the circumstances, the pension input amount is worked out by calculating what would be the value of the pension input amount for each type of benefit that could be provided from the hybrid arrangement, and taking the highest of these values.
Annual allowance reporting
27.To help individuals know whether or not they may be liable to an annual allowance charge, if their pension input amount in a particular registered pension scheme exceeds the annual allowance for a tax year, the scheme administrator must provide the member with a pension savings statement by 6 October in the following tax year. The statement tells the member about their pension savings in that scheme for the tax year concerned, plus the three previous tax years. Individuals can also request this information from their scheme administrator if it would not be automatically provided to them.
International
28.There are circumstances in which an overseas pension scheme that is not a registered pension scheme will contain funds that have benefitted from UK tax relief. For example, where an individual comes to the UK as a member of an overseas pension scheme, contributions to their overseas scheme may benefit from UK tax relief just like contributions to a registered pension scheme. Funds in an overseas pension scheme which have built up in a registered pension scheme before being transferred to the overseas pension scheme will also have benefited from UK tax relief.
29.Finance Act 2004 therefore contains charging provisions which apply in certain circumstances to members of non-UK pension schemes which are intended to reflect similar charges that would have applied had those funds been held in a registered pension scheme. However, for members of non-UK pension schemes, these charges only relate to the part of the member's non-UK pension fund that has benefitted from UK tax relief.
Background to the changes
30.The Government announced at Budget 2014 proposals to allow people aged 55 and above, from April 2015, to access their money purchase pension savings as they wish. These reforms mean that individuals with money purchase savings will be able to access their entire pension fund as they wish after age 55. This will allow individuals to make their own choices about how to use their pension savings.
31.As an interim measure a number of changes were made to the existing pension tax rules, to extend the circumstances in which an authorised member payment could be made. These changes were enacted in the Finance Act 2014, had effect from 27 March 2014 and amended Finance Act 2004 to:
increase the maximum income that a drawdown pensioner (member or dependant) with a capped drawdown pension fund can choose to receive up to 150 per cent of the “basis amount”;
reduce the minimum income threshold for flexible drawdown to £12,000;
allow members aged 60 or over, with total pension savings of £30,000 or less, to take out all of those savings as one or more trivial commutation lump sums;
increase the small pots limit to £10,000; and
increase to 3 the number of small pot lump sums that can be taken under non-occupational pensions.
32.A consultation document “Freedom and choice in pensions” published on 19 March 2014 set out the Government’s proposals for reform and invited comments from a range of stakeholders on the changes announced at Budget 2014. A summary of responses to the consultation was published on 21 July 2014.
33.The summary of responses set out that the Government would take forward two separate pieces of legislation during the autumn of 2014 to deliver the changes: the Pension Schemes Bill and the Taxation of Pensions Bill.
34.The Pension Schemes Bill was designed to deliver the regulatory framework for defined ambition pension schemes, and included provisions to enact the guidance guarantee and the restrictions on transfers from unfunded public service defined benefit schemes. It also included changes to pensions legislation to ensure that individuals could access their pension savings flexibly.
35.A draft of the Taxation of Pensions Bill was published on 6 August 2014 for a four week technical consultation, to ensure that the legislation would enact the policy as intended. In total, 45 written responses were received.
36.The Government announced on 29 September 2014 that, from 6 April 2015, the tax charge on certain death benefits would be reduced.
37.The Taxation of Pensions Bill introduced into the House of Commons on 14 October 2014 had a number of changes either:
as a consequence of consultation responses as well as making a number of technical improvements; or
to introduce new provisions on tax charges on death, international pensions and reporting requirements.
38.Amendments were made to the Bill during its committee and Report stages in the House of Commons. The amendments introduced during the Commons committee stage made changes so that any individual, not just a dependant, can inherit unused drawdown funds or uncrystallised funds on the death of the member where those funds are then used to provide a drawdown pension or pay a lump sum death benefit. Where the death of the member occurred before age 75, the changes enable any payments of income withdrawal to the beneficiary to be made tax-free providing the funds are designated to the beneficiary’s drawdown fund within a two-year period and that the member had sufficient lifetime allowance available at the time of their death.
39.Amendments were also made to ensure that the equivalent of income withdrawal paid from a non-UK pension scheme will get similar tax treatment.
40.Further amendments were made at the Commons Report stage so that the reporting arrangements introduced by the Act in respect of the money purchase annual allowance apply only to active members of pension schemes.
The maximum that can be paid under capped drawdown was increased from 120% to 150% of the basis amount for drawdown years beginning on or after 27 March 2014.
The Minimum Income Requirement was reduced from £20,000 to £12,000 for flexible drawdown declarations made on or after 27 March 2014.
The trivial commutation limit was increased from £18,000 to £30,000 for commutation periods beginning on or after 27 March 2014.
The small pot limit was increased from £2,000 to £10,000 for payments made on or after 27 March 2014.