As a high earner we need to ask ourselves some important questions when it comes to investing monies into pensions. Presuming you have created a full financial planning cash flow model and established a need and quantified that need the interesting bit starts.

Previously if there was a shortfall you could bridge that shortfall by contributing up to 100% of your income up to the annual allowance of £255,000 (09/10) and receive the full 40% relief. Once we had made sure there was a positive tax shift (i.e. 40% relief now but with only basic rate tax to be paid in retirement) it was simple.

The rules have changed some what since then and this article is to give you an insight so that you maximise the relief's available and as importantly do not over contribute and increase the possibility of creating a negative tax shift (i.e. 20% relief now but 40% rate tax to be paid in retirement).

Let us look back at the 2009 Finance Act and other changes previously announced:

Frozen Annual and lifetime Allowances:

The lifetime limit will remain at £1.8m for at least five tax years from 6 April 2010 for those who do not benefit from transitional protection. The normal annual allowance for 2009/10 is £245,000 but for 2010/11 and subsequent tax years it will be £255,000. The annual allowance is based on the tax year in which the pension scheme's 'input period' finishes. For many schemes the input period is the same as the tax year but it can be changed if necessary and, subject to having sufficient earnings, would allow a contribution of up to £500,000 in 2009/10 and £510 000 in 2010/11.

Removal of Personal Allowance:

From 6 April 2010, personal allowances will be reduced by £1 for every £2 of adjusted net income over £100,000. This could result in an effective rate of tax of 60% for individuals earning between £100,000 and around £112,950 (twice the standard personal allowance). For example, someone with an income of £110,000 would not only be liable to 40% tax on the top £10,000 'slice' of their salary but would also lose £5,000 of their personal allowance (£1 for every £2 above £100,000). This amount of £5,000 would be liable to 40% tax, meaning the overall tax liability on the individual's top £10,000 slice of salary is effectively £6,000, or 60%. Pension contributions can help to avoid this problem (see below).

Pension tax relief restrictions:

From 6 April 2011 the government intends to restrict tax relief on contributions paid to pension schemes for those with income, from all taxable sources, of more than £150,000 per annum. Where income is in excess of £130,000 then the value of any employer pension contributions will be added back to determine whether the £150,000 threshold has been breached. A gradual tapering away of tax relief until only 20% relief is available for those with income over £180,000 per annum.

This could create a negative tax shift as 20% relief now could be offset by paying 40% on pension income if you have accumulated sufficient pension funds/other assets so that you are a higher rate tax payer in retirement.

In the meantime HMRC has introduced anti-forestalling rules which have the effect of restricting higher rate tax relief on pension contributions in excess of £20,000 (or up to £30,000 in some circumstances) per tax year and paid between 22 April 2009 and 5 April 2011.

The restriction only applies to individuals who have taxable income (known as 'relevant income') of greater than £130,000 in 2009/10 or the two previous tax years (i.e. 2007/08 and 2008/09).

However, if contributions were paid between 22 April 2009 and 8th December 2009 then the income threshold is £150,000 (including for the previous two tax years). For contributions made between 6 April 2010 and 5 April 2011 it will apply if taxable income exceeds £130,000 in 2010/11 or the two previous tax years (i.e. 2008/09 and 2009/10).

The definition of 'relevant' income':

The calculation of relevant income involves six distinct steps:

1. Identify total taxable income in the tax year. This will include earned income, investment income (interest, dividends etc.) and rental income.



2. Add in any occupational pension contributions made under the net pay arrangement, which are not otherwise treated as taxable income.



3. Subtract qualifying losses arising from trades or property.



4. Subtract pension contributions, up to a maximum of £20,000.



5. Add in the amount of any salary sacrifice started after 22 April 2009.



6. Subtract any charitable donations made under Gift Aid.

If the result is £130,000 or more (or £150,000 in respect of contributions made between 22nd April 2009 and 8th December 2009) the individual is subject to the special annual allowance otherwise they are not.

If you are caught by the anti-forestalling rules, then the maximum contribution that you can make to a registered pension in 2009/10 and 2010/11, before incurring a tax charge known as the special annual allowance charge, will be limited to the higher of £20,000 (known as the 'special annual allowance') or pre 22 April 2009 regular contributions (known as 'protected inputs').

If you don't have protected inputs of more than £20,000, but have previously made 'irregular contributions in any of the three previous tax years to the tax year in which you wish to make the new pension contribution, you may be entitled to make a contribution of more than £20,000 in either 2009/10 and/or 2010/11 and avoid the special annual allowance charge.

The special annual allowance is increased to the lower of £30,000 and the average of the irregular contributions paid over the three prior tax years to the extent that this would permit a contribution in excess of £20,000 in the current tax year without incurring the special annual allowance charge. Any existing regular contributions (protected inputs) would be deducted from the special annual allowance to determine the scope of any additional contribution.

Planning options

So if you are caught by the income definition, what can you do if you want to make pension contributions of more than £20,000 in this or the next tax year? Well here are a few ideas that might work for you.

Protected inputs - If you and/or your employer were making regular (i.e. at least quarterly) contributions to a pension plan before 22 April 2009, or the contract was entered into before that date, make sure that you continue those contributions. If you transfer the pension plan to an alternative provider then the protected inputs will cease, although some providers will allow a partial (and substantial) transfer out of benefits but continue to receive regular contributions into the original plan. Check with the existing provider and get their response in writing.

Trading losses - Allocate trading losses from another business, possibly an LLP, against current or previous taxable income so that it brings taxable income below £130,000 (or £150,000 is applicable).

Charitable donations - If you have no trading losses but taxable earnings of less than £130,000 (or £150,000 if applicable) in 2007/08, then make a charitable gift to a registered charity for the current or previous tax year, as this will reduce your income for pension forestalling rules by the amount of the contribution.

Defined benefits SSAS - If you are a company director, consider establishing a defined benefits small self administered scheme (SSAS). This may well allow a cash contribution higher than £20-30,000, if the cost of providing annual income at retirement age is higher. This is because the rules define the cash contribution for a pension scheme which provides defined benefits (a promise of a specific amount of pension in the future) as equal to ten times the benefit accrued.

So an income benefit of £2,000 (with inflation protection and survivor's pension) will be treated as a £20,000 contribution, even if the actuarial cost (and the amount your company would contribute) might be, say, £50,000.

Employ your spouse - Since HMRC lost the case of 'Arctic Systems' and has twice dropped the expected blocking legislation due to human rights conflicts, it seems perfectly reasonable to carry out 'income shifting' by employing a spouse, together with an appropriate pension contribution. An employer (whether limited, LLP or sole trader) may contribute up to the annual allowance for an employee, regardless of how much income the employee is paid.

Personal contributions are limited to the lower of 100% of earnings or the annual allowance (£245,000 for input periods ending in 2009/10). A word of caution on this strategy: it would be sensible to ensure that the salary and pension paid to the spouse is 'reasonable' relative to the work being undertaken. In addition, the pension contribution paid by the employer will be subject to the 'wholly and exclusively' test to determine that it will be deductible for tax purposes. However, given the number of family members working for MPs and being paid nice salaries and accruing pension benefits in the generous parliamentary pension scheme I think HMRC is on shaky ground here!

Not caught by the 'relevant income' conditions?

If you are not subject to the anti-forestalling measures then here is a list of planning points to consider prior to 6 April 2011:

• Make personal contributions up to 100% of earnings to the extent that they receive tax relief at 40% (or 60% if your income is between £100,000-112,950 in 2010/11);



• Agree any future bonus or remuneration be paid to your pension scheme by your employer, up to the annual allowance of £245,000 in 2009/10 or £255,000 in 2010/11. Employer contributions are not subject to the employee's requirement that they have corresponding earnings to justify the contribution but they do need to be reasonable and not part of a post 22 April 2009 salary 'sacrifice' arrangement;



• If income is below £130,000 in the current and previous two tax years, before any salary sacrifice/exchange occurs, it will continue to be attractive as a means of reducing tax and national insurance contributions.



• Where a) cash is tight, b) you have assets that have an uncrystallised loss that you would like to carry forward or c) you have unrealised capital gains that you would prefer to be taxed at the currently beneficial rate of 18% (after annual exemption and current year losses) consider making pension contributions 'in specie' i.e. by transferring property or investment funds/holdings to the pension. As well as crystallising the loss or gain on the asset transferred to the pension, you will receive tax relief at your highest rate. Property can be part-owned personally and by your pension scheme so, if needed, the contributions could be straddled over the current and next tax year.

Summary:

There are a lot of changes going on but in order to maximise the allowances available to you please don't hesitate to contact your adviser.

Bob Hudson CFP

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