On 6th April next year the Government's plan to reduce the size of the amount any individual can invest in their pension comes into effect. From that date the annual tax-deductable allowance that can be paid into a pension reduces from £50,000 to £40,000. This is part of the UK Government's aim to restrict the amount of tax relief given to individuals, thereby increasing tax revenues and helping it to play down the UK's huge public sector debt. To many readers this reduction in the size of the tax-free allowance will sound like something only the relatively rich need to concern themselves with. However, as Derek Blaik explains, even those on relatively modest salaries could find themselves caught by the change. If they are, they could be looking at punitive additional tax bills.
"When an individual gets a significant salary increase and the individual is a member of a"final salary" pension scheme, this will usually also mean an increase in pension benefits by a proportionate amount. What you have to realise is that the Inland Revenue work out what the equivalent sum as a one-off lump sum payment would be, by multiplying the additional pension sum by a factor of 16," Derek points out. Under this rule if the sum accruing in your pension was increased by £2,500 a year (after inflation is considered), then the x16 factor automatically puts you at the £40,000 limit. Anything accrued over that would attract tax at up to your highest tax rate.
For this reason Derek points out that mid-tier and higher-paid employees need to be aware of the changing pensions landscape, and it may well be that they need to consider working out an arrangement with their employer where they are given cash in lieu of an additional pension contribution. This change also coincides with a reduction in the Lifetime Allowance on pension funding from £1.5m to £1.25m from April 2014. The higher personal income tax rate of 40% (45% for those earning over £150,000 per annum) is actually substantially lower than the 55% tax you would have to pay on any lump sum in excess of £1.25m built up in your pension fund, leading to a potential tax saving of up to 15%.
"What we are seeing are higher earners and high net worth individuals increasingly looking for alternative, tax efficient ways of saving. The old traditional habit of pushing as much as possible into the pension plan has given way to looking at alternative, tax efficient investments. These include diversified investment portfolios and offshore investment bonds. Offshore bonds offer the opportunity to defer any liability to income tax for a potentially long period.
For the investor willing to take a high level of investment risk, Enterprise Investment Schemes (EIS), which have been around since 1994, and where investments in qualifying companies offer valuable tax breaks. Venture Capital Trusts (VCTs) also offer attractive tax breaks, including income tax relief on qualifying investments. However, Derek points out that individuals need to take professional advice here."We have seen several instances where, although the investor gained tax relief through an EIS or VCT scheme, the company itself lost substantially so that the investment as a whole created a significant loss for the investor".
"Individuals really do need to take care and seek professional advice when considering these pension rule changes and any alternative investment strategies," he comments.
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