Untangling the pension knot

Saving for a pension will be less complicated in a couple of years. That is the promise to anyone planning for retirement after April 2006 when eight complicated tax regimes will be swept away and replaced by one simple set of rules applying to all kinds of pension. At the moment how much you can save, when you can retire, and what you can do with your pension fund depend on when you started saving and what kind of pension scheme you are saving with.

But from April 2006 it will be much simpler. Everyone, working or not, will be able to put up to £3600 into a personal or stakeholder pension. People who work will be able to put in as much as they earn in the year subject only to an upper limit of £215,000. That upper limit will rise by £10,000 a year to reach £255,000 by 2010/11.

Although these upper limits may not affect most of us – the government estimates only around 1000 people a year – the fact that we can now put as much money into a pension as we earn in the year has important implications. At the moment, the limits are 15 per cent of earnings for employees paying into a company scheme, and on a sliding scale from 17.5 to 40 per cent, depending on age, for people paying into a personal pension.

The new relaxed regime will be especially useful to people in their fifties. At that age we are more likely to get a redundancy payment, a lump sum from an investment, or an inheritance. Under the new rules that money may be able to go straight into a pension and get full tax relief, even if it was paid tax-free in the first place. For example, if you earn £30,000 and get a redundancy payment or inherit £20,000 you will be able to put that money straight into a pension plan and get £5641 tax relief added by the Government making a total of £25,641 towards your pension. Under existing rules someone in their fifties is limited to 35 per cent of earnings going into a personal pension.

However, the current rules which allow pension contributions to be ‘carried back’ and counted as if they had been made in a previous tax year will go from April 2006. So to take advantage of the new rules the contribution has to be made in the same year the income was earned.

Another new rule will make life a lot easier for people with a small amount of pension savings. From April 2006, pension funds of up to £15,000 can be cashed in. There are two restrictions. First, you must be between 60 and 75. Second, you can cash in any number of funds – as long as the total value is no more than £15,000 – but all must be cashed within a twelve month period.

When you cash the fund in you will be able to take a quarter of it tax-free. The rest will be taxed as if it was income – so if you pay basic rate tax then you will lose 22 per cent of the balance of the fund.

The cashing in limit will rise each year to 2010/11 by which time it will be £18,000. As the average pension fund is around £25,000 many people will be helped by this new rule. If you are approaching 60 and planning to retire in the next year or so, it may be worth delaying that until the new rules begin in April 2006. At the moment the limit for cashing in is just £2500.

At the other end, there will be a new lifetime upper limit of £1.5 million in a pension fund. That is not just money that has been put in, it is the total value. Any excess will be taxed at 55 per cent before being converted into a pension. The restriction will also apply to people with pensions related to their pay. These have no individual pension fund, but the government will allow a pension only up to £75,000, or a lump sum of up to £375,000 and a pension of £56,250 a year. The overall limit will be raised year by year to 2010/11.

There will also be more freedom about what you do with your pension fund. You will always be able to cash in up to 25 per cent of it as a tax-free lump sum. And there will be more flexibility about what you do with the rest. You will have to buy an annuity – a pension for life – at 75. But before that you will be able to use a variety of ways to draw income from the fund. The minimum age to get your pension will rise from 50 to 55 in 2010.

Inheritance Tax – no reprieve
There was bad news in the Budget about Inheritance Tax. The rate at which it bites was raised by just 3 per cent to £263,000. But figures from Halifax indicate that house prices in the last twelve months have risen by 18 per cent. So more estates will be dragged into the tax net. The Government is also clamping down on schemes to avoid the tax. An estimated 30,000 people have signed up to schemes which allow them to give away their home but continue to live there and avoid inheritance tax on their estate when they die.

Normally, if you give your home away – to your children for example – but do not move out or pay them a market rent, the law states that inheritance tax is still charged. It is technically called a ‘gift with reservation of benefit’ or GROB. In other words you give the property away but continue to benefit from it. As far as inheritance tax is concerned, you never gave it away at all. When you die the house will count as part of your estate and tax may be charged.

Over the years, accountants and lawyers have devised ways round this rule. One method is to give the home to a trust and, by using a second trust or IOUs for the value of the home, the GROB rules can be circumvented. Although the scheme was legal, there was no other purpose to it except to avoid tax. The Government has said it will change the rules to stop these schemes working. They will still avoid inheritance tax. But from April 2005 the people who live in the house will be charged income tax on the value of the benefit they have from it. The charge will be based on what it would cost to rent the home. If that would cost £10,000 a year, then they will have to pay tax on that amount. At basic rate it would cost them £2,200 a year to live in their own home. The new rules will not just apply to houses – the scheme has been used to hide valuable property such as paintings or antiques from IHT. All such deals entered into since the start of Inheritance Tax in 1986 will be caught by the change.

People who have already entered into such an arrangement can escape the tax by stating that they will pay IHT on the property they have given away. This declaration does not have to be made until 31 January 2007. Accountants are recommending that people affected do not sign until the last possible moment in case the Government, or a future one, changes the rules again.

The Government has made it clear that the new rules will not apply in some circumstances. They include the scheme mentioned in this column where a couple split the value of the home between them and each leaves half to their children (Saga Magazine December 2002). The new rules will also not bite when a parent or grandparent has helped children or grandchildren onto the property ladder and taken part of the value of the home as payment, even if they then go and live in the home. And if someone moves in with an older relative and is given an appropriate share of the home that will not be subject to IHT either. However, the full details of these and other concessions may not be clear for some time.

The Government has also warned it will clamp down on any artificial scheme to exploit legal loopholes to avoid tax. So beware complex schemes to avoid tax. They may not work. And it is you or your relatives who will pay the penalty, not the company who sold the plan to you.

Extra £100 for over 70s
People aged 70 are to get an extra bonus this winter. It will be £100 for every household where a person aged 70 or more lives. The Government says "it is right to help older pensioner households with their council tax." But the extra payment is not related to council tax at all. It will go to households on limited incomes who already get all their council tax paid and those where the older person lives with younger relatives. The extra money, which will be tax-free and will not affect pension credit or any other benefit, and will almost certainly be paid with the winter fuel payment. In practice the winter fuel payment will now be £200 for people aged 60, £300 for those aged 70, and £400 for those aged 80. In each case the qualifying date is expected to be 26 September 2004 – so the new payment will go to anyone born on 26 September 1934 or earlier and will be paid in November.

May 2004

e-mail Paul Lewis on paul@paullewis.co.uk