Tax implications of pension arrangements

The percentage applied to calculate your NICs was based on the contracted-out salary related occupational scheme.

Whereas State pension does not provide individuals with a high income on retirement, many employers can attract employees by establishing occupational pension schemes to supplement their emoluments when they reach pensionable age.

The two types of occupational pension scheme are salary related and money purchase schemes.

Money purchase scheme

It is reliant on the amount of contributions made into the scheme, as well as on the value of the investment fund, the age when fund is used to purchase an annuity, the annuity rates at retirement and the additional benefits offered.

Annuity is a form of investment sponsored by insurance company or other financial institutions that pays a member a regular retirement income on the invested amount.

Money purchase scheme obliges employer to pay fixed amount between two to ten percent of employee’s salary towards his/her pension. In addition, both employee and employer can pay installments into the retirement fund and receive tax relief for those contributions.

Final salary pension scheme:

One of the benefits that you have received from employment in Flute Plc was salary related scheme. As a contracted out occupational scheme it offers you a lower,  9.4 % rate payable for National Insurance, while normally this would be 11%.

According to final salary scheme, your pension depends on the number of fiscal years of employment, the size of your final salary and, if it is a Career Average Revalued Earnings Scheme (CARE), on the ‘accrual rate’.

CARE is a type of final salary scheme where employer is able to control and reduce the sums payable towards the pension. Employers typically pay around 14.2% of the salary, whereas CARE scheme uses ‘accrual rate’ to calculate the contributions payable.

Accrual rate is the proportion of your salary that is received for each year of your service. Although it might be different rates, the most typical are 1/60th or 1/80th of the final salary.

In your case, the benefit will be based on one completed year of employment. Therefore the size of your pension would be your pensionable service multiplied by your final salary and divided by ‘accrual rate’. Assuming that your annual income equals to £220,000 and applicable accrual rate is 1/60th, the formula would be.

As you can see, the longer you stay in the scheme, the higher pension you might expect. However, the maximum pension you can get from the final salary scheme is 2/3rds of your ultimate income.

The principal advantage of final salary arrangement is a secured size of your retirement fund that does not fluctuate due to the performance of investments, as it does in case of money purchase scheme.

It also offers tax relief for your and your employer’s contributions, together with additional benefits, such as provision of pension to the partner in the case of member’s fatality.

On the other hand, final salary scheme conditions high contributions payable by your employer. Hence, many companies are prone to wind up the scheme, as they become insolvent to meet their liabilities. Therefore, members might lose part or whole of their retirement income.

Final salary scheme is complicated in relation to transfers. It depends on the period of membership and contributions made towards your pension.

Leaving the company after two years of employment would give you two options. These include leaving and preserving your pension until you will reach pensionable age or transferring it to a new scheme in order to enhance your retirement benefits.

As you decided not to contribute towards your final salary scheme, you are not eligible for any contributions’ refund or tax reliefs applicable to the early leavers.

Personal Pension Schemes

In contradistinction to your occupational scheme offered by Flute plc, self-employment obliges you to accept all the risks and contributions payable towards your chosen pension schemes.

As a self-employed you are required to pay Class 2 NICs with applicable weekly rate of £2.30. Since your trading profits exceed lower threshold of £5,435, earnings-related Class 4 NICs are payable towards your State pension applying 8% to your first annual income of £40,040 and 1% to the earnings above the threshold.  

Lower National Insurance contributions mean that you are not covered by State second pension. However, you can choose the additional private pension.

From 6 April 2006 you can belong to a variety of different pension schemes.

When choosing pension scheme, you should prefer the one registered with Pension Regulator to acquire tax reliefs and exemptions from income and capital gain taxes.

Generally private pension plan is a money purchase arrangement which offers up to the 25% proportion of your pension fund as a tax-free lump sum. This can be withdrawn when you reach age 50 (rising to 55 in April 2010). The residual value is used to purchase an annuity. Although, if your retirement fund or the total of funds is less than £15,000, you can take out the entire amount as a lump-sum where a quarter of it would not be taxable. You should also consider the fact that it is not necessary to withdraw money from your pension fund as that amount decreases your annuity investment and therefore, your accessible pension income.

Stakeholder pension is a type of a low cost personal pension which is generally provided by insurance companies. Contrary to regular personal pension it will offer you restricted options of investments. However, you will get an advantage from low minimum contributions (£20) and a freedom to choose the size and frequency of investments. It is advisable as you may face irregular earnings due to unpredictable performance of your new business. You can also transfer your scheme to another provider without penalty and as in other personal schemes, you are able to contribute even if you will decide to change your job.

If you seek for more control over your investments you can choose Self invested personal pension scheme (SIPP). You can decide the type of investments and directly manage it. SIPP allows you to borrow up to a half of your retirement fund value, which can be used to buy shares, unit trusts and bullion, as well as commercial property e.g., your warehouse. Your pension might significantly escalate if your investments increase in value. On the contrary, you might have to use a part or the entire fund to cover the losses. Disadvantage of the scheme is a high cost of administration. Although due to the competitive market, there are three types of low cost SIPP:

• Low cost SIPP - where investments choice are limited
• SIPP provided by insurance companies - where you have to invest certain amount into provider’s own pension funds, equities or property.
• SIPPS from specialist providers - which offers the variety of investments that may be invested by you or on your behalf.

Another disadvantage arises if you will decide to buy a property from a loan taken out of your pension fund. Your acquired property will actually be owned by your pension fund. Therefore you will be dependent on trustees’ decisions. 

Annuities

There is also a multitude of annuities in the market and it is essential to choose the best option corresponding to your needs.  

There are annuities that concentrates on the benefits provided to your family after your death. Such are:

• guaranteed period annuity which pays income for a guaranteed period to a maximum of ten years
• protected period annuity where the total of your unused retirement fund is paid to your nominee if you die before the age of 75
• joint life annuity that pays income to your financially dependent partner until she/he dies  

These types of annuities cause lesser primary income received in the first years of your retirement.

 

If you are interested in higher retirement income you might be offered more risky annuities like ‘investment-linked’ and ‘with-profits’.  The investments are made in the stock market as for investment linked annuity or in insurance companies with profit funds. Although the income from these annuities is not guaranteed as it is dependent on investment performance and may fall as well as rise.

You can also invest into your child’s pension in the form of a child trust fund or private pension. Whether or not a child is earning an income, it is possible to make contributions up to a total of £3,600 per year into a fund which is free from income tax. Therefore you will be paying only £2,880 per annum. The pension will earn tax free interest until your child starts taking the pension. The difference between a child trust fund and a pension fund is that the latter cannot be accessed until your child reaches pensionable age whilst with a trust fund it can be done from the age of 18.

Private pension investments can grow free of income and capital gains tax. Tax relief on your contributions is only given in the tax year that you have paid your contribution. This is because the pension provider can claim this relief from HM Revenue & Customs at the basic rate of 20%. As you are a higher rate taxpayer you can claim additional 20% on your annual tax return, or by sending a letter to tax office.

If your pension fund excluding tax free lump sum exceeds the annual allowance of £235,000 as for 2008/2009, it is subject to income tax.

Before you choose a pension scheme, you need to consider the age at which you intend to retire, the size of your basic state pension, your lifestyle and living expenses, dependants and any additional expenses that might arise due to your retirement.

You are also allowed to get basic pension based on your husband’s or partner’s NICs contribution (Different rules are applicable for each of the situation listed above)

In order to protect your entitlement for the period of time when you being out of employment you could have claim Earnings credits (e.g. jobseekers allowance), as the earnings for this period will ensure the fact that no basic state pension entitlement is lost.

The other option is to make a claim under Home responsibilities protection, assuming that you used part of your unemployment period to take care of your child.

Yours sincerely,

LSBU Accountancy

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References

Books:

MELVILLE, A. (2009) Taxation. Finance Act 2008 14th ed. Harlow: Financial Times/Prentice Hall

HARRISON, D. (1997) Pension Power. Understand and control your most valuable financial asset 2nd ed. Chichester: John Wiley & Sons Ltd

LABOUR RESEARCH DEPARTMENT (2001) Finding out about your pension London: LRD Publications LTD

Websites:

http://www.hmrc.gov.uk [Accessed 1 February 2009]

http://www.opsi.gov.uk [Accessed 1 February 2009]

http://www.businesslink.gov.uk [Accessed 1 February 2009]

http://www.taxationweb.co.uk [Accessed 1 February 2009]

http://www.thepensionservice.gov.uk [Accessed 1 February 2009]

http://www.thepensionstrust.org.uk [Accessed 1 February 2009]

http://www.sharingpensions.co.uk [Accessed 1 February 2009]

http://www.moneymadeclear.fsa.gov.uk [Accessed 1 February 2009]

http://www.pensionsboard.ie [Accessed 1 February 2009]

http://www.pensionsorter.co.uk [Accessed 1 February 2009]

http://www.pensionschampions.org.uk [Accessed 1 February 2009]

http://www.rightannuity.co.uk [Accessed 1 February 2009]

http://www.annuitydiscount.co.uk [Accessed 1 February 2009]

http://www.moneypage.com [Accessed 1 February 2009]

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