New tax laws will seriously limit the ability of high-earning UK contractors to make adequate financial provision for their retirement, according to an expert independent financial adviser.
Successful contractors earning at the higher end of the scale have had their tax planning and future retirement income seriously disrupted following new pension rules introduced by the Chancellor in April’s Budget.
Previously, contractors have been able to invest significantly into pension funds, in line with government recommendations, but from April 2011, contractors earning over £150,000 per year will lose tax relief on their pension contributions.
“Until now, contractors have legitimately used pension contributions to invest tax efficiently and to plan for their retirement – a strategy strongly encouraged by a government keen to get people to save for their futures,” explains the IFA expert. “Removing and reducing tax relief sends some very mixed messages. This is especially concerning as there’s a element of retrospective taxation which is against long-established principles of taxation policy.”
Changes to tax relief
Since pension simplification rules were introduced in 2006, contractors have been able to reduce significantly their tax liabilities by contributing a substantial proportion of their income into a pension scheme.
In fact, for many contractors the amount they could invest to provide an income in their retirement was virtually limitless – up to £245,000 per year with a lifetime allowance of £1.75m, based on 2009/10 allowances.
Removing and reducing tax relief sends some very mixed messages. This is especially concerning as there's a element of retrospective taxation which is against long-established principles of taxation policy
IFA expert
But, as the IFA expert explains, this has all changed: “The Budget revealed that from April 2011, contractors earning over £180,000 per year will have their tax relief capped at the basic rate of 20%, with contractors earning between £150,000 and £180,000 per year receiving relief on a sliding scale of between 20% and 40%.”
Anti-forestalling rules = retrospective taxation
And, warns the expert, for those fleet of foot contractors who might pile in the cash while they can, the Chancellor was ahead of the game: “Anti-forestalling rules have been put into place to prevent high earners from maximising contributions over the next two years.”
Contractors who have earned £150,000 or more in the last two years will only receive 20% tax relief on their pension contributions above a ‘special annual allowance’ of only £20,000, which includes contributions from the contractor’s net earnings and their limited company.
“Contractors who earn up to £149,999 could technically invest the lot in a pension scheme with no tax liabilities,” says the IFA expert. “But if they earn £1 over the limit – easy to do as earnings include income from all sources including rental income from property, dividends from investments and bank interest – then the special annual allowance applies.”
Contractors who pay in over the limit will have to make a repayment of the balance between the basic and higher rate tax relief via their self-assessment tax return.
Regular contributors still benefit
“Those contractors exceeding the £20,000 limit who have historically made regular pension contributions on a monthly or quarterly basis prior to 22 April 2009 can continue to benefit from their current tax relief allowances, as long as they maintain the regular contributions,” explains the IFA expert.
Contractors who made regular pension contributions will be able to continue with the contributions as ‘protected input amounts’. For example, a contractor who has regularly contributed £3,000 per month can continue to enjoy 40% tax relief.
Unfortunately, contractors who have made irregular contributions and those investing a lump sum each year won’t qualify for this benefit, and contractors tempted to switch pension providers will lose their ‘protected input amount’ benefits altogether.
Key contractor pension opportunities
For contractors earning under but near £150,000 per year, now is the time to invest, advises the expert: “Contractors earning under the limits still attract full tax relief, and as we’ve just seen, those who had previously invested on a regular basis seem to have dodged the bullet with regard to the new rules. It could very well be the case that any future tightening of the rules may not apply to prior arrangements either.”
For those earning £150,000 to £170,000 the IFA expert has identified a quirk of the anti-forestalling rules. Contractors could first use up the £20,000 pension limit via salary or dividend sacrifice which would reduce their income below the earnings cap, thus enabling them to invest further without the restrictions.
Finally for those earning over £150,000, the IFA expert believes a pension is still a highly tax efficient investment vehicle, as those contractors investing the full £20,000 are effectively receiving a subsidy of £8,000 from the taxman, which is a very good initial ‘return’ when compared to other investment opportunities.
With increasing pressure on sustaining retirement incomes from the state, the IFA expert feels it is unlikely that higher rate tax relief will be abolished completely. He concludes: “Contractors have an even greater incentive to invest in a pension that provides for their retirement, particularly with the increases in taxation for higher earners announced in the budget.”