Page last updated at 16:41 GMT, Sunday, 20 December 2009

How pension contributions of the rich will be taxed

By Ian Pollock
Personal finance reporter, BBC News

Alistair Darling
The Chancellor Alistair Darling looks for rich people to tax

Very big tax bills are looming for high earners, coming into effect first in April 2010 and then in April 2011.

As previously explained, about 300,000 people face the prospect of paying an average of £20,000 in extra tax each year.

For many of those who earn more than £150,000 a year, the biggest change will be to the taxation of their pension contributions from 2011.

The widespread view among pension advisors is that all the changes taken together will have a big unwanted knock-on effect on ordinary pension scheme members too, not just the highest paid who are being targeted by the government.

"This may accelerate the closure of final salary pension schemes," says Tom McPhail of investment advisors Hargreaves Lansdown.

"It will undermine the alignment of interest between the higher paid staff, who are usually in charge of pay and pension policy at employers, and the other scheme members," he says.

Who will pay?

Higher paid taxpayers who make pension contributions, or who receive them from an employer, now need to ask themselves some questions.

You can be blissfully throwing money into your pension scheme and then later realise you have won the opportunity to write the Revenue a cheque
John Whiting, CIOT

If their total incomes are below £130,000 then they fall outside the scope of these new pension tax rules completely.

If their incomes are £130,000 or more, they need to add on the value of their employer's contributions.

If that total, known for these purposes as "gross income", is £150,000 and over then the new system kicks in.

Pension tax relief on their own contributions will be tapered down from 50% at £150,000 per year to just the basic rate of 20% once their income reaches £180,000 or more.

For individuals in this position it will generate a retrospective tax charge of up to 30% on those contributions for the past year.

The additional and very dramatic change in tax policy is that income tax will also be levied on the value of their employer's contributions, also at a rate of up to 30%.

The size of the eventual bill could come as a big surprise.

"You can be blissfully throwing money into your pension scheme and then later realise you have won the opportunity to write the Revenue a cheque," says John Whiting of the Chartered Institute of Taxation (CIOT).

"This is absurdly complex to achieve what they want."

Final-salary schemes

If someone is a member of a defined contribution pension scheme it will be easy for their scheme administrator to add up just how much money the employer paid in during the particular tax year and tell the taxpayer.

Reading a tax return
Filling in a tax form will become even more complicated

But the situation is different and much more complicated in traditional final-salary schemes.

Here the actual contributions can be measured easily too, but that will not be the information required to fill in a self-assessment tax form.

That is because the value of the eventual pension will have been ratcheted up, partly as a result of someone paying in for one more year, but mainly because of the effect of any pay rises.

These will increase the member's final pensionable salary and hence their pension too, far beyond the mere value of the extra cash contributions.

The Government Actuary's Department has come up with three possible methods of measuring this, and the government favours one of them.

In this preferred version, a pension scheme administrator will have to use a scale of factors, adjusted for age and normal retirement age, and apply them to the increase in someone's prospective pension.

This will generate an estimate of the cash sum needed to buy the increase in pension that has been accrued in the past year.

That is the figure individuals will use for their tax returns.

It will be a particularly big sum for staff close to retirement, especially if they are given a large pay rise.

"I'll be surprised if anyone pays tax at that level," says Bhargaw Buddhdev at the actuaries Barnett Waddingham.

"We will be advising clients not to stay in a scheme until they are 64 - I'd advise them to opt out and get some sort of cash benefit instead, as it will not longer be tax efficient to take pension contributions.

"The simplest option is just to take a pay rise instead and invest it for yourself," Mr Buddhdev says.

'Too big'

It is worth noting that a crude form of the new pension tax regime has already come into force.

They are clearly anticipating that some bills will be too big for some people to pay
Andrew Meeson, ATT

This is because of the "anti-forestalling" regulations, aimed at stopping people from stuffing their pension schemes with extra cash to gain the benefit of the enhanced tax relief before it gets taken away in 2011.

What is someone do with all the extra tax information they receive, apart from gulp?

On the face if it the answer is simple: fill in the annual self-assessment tax form.

But this will now be even more of a chore than before, containing more boxes, pages and guidance forms.

Some experts think many people earning more than £150,000 a year will simply give up making pension contributions.

"It's not just the manner in which the charge is worked out for final salary schemes, which is a deterrent to people making pension provision close to retirement," says Andrew Meeson of the Association of Taxation Technicians (ATT).

"The very existence of the charge is a deterrent, and just as much for money-purchase schemes."

If the tax charge is more than £15,000, tax payers will have some options.

Instead of paying up in one go, they may be able to spread the payment over three years.

Or they could ask their pension scheme to pay the charge in exchange for a reduction in their pension pot or accrued pension entitlement.

"They are clearly anticipating that some bills will be too big for some people to pay," Andrew Meeson says.

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