There was a Spring Budget today. Presumably this wasn’t news to anyone, but as far as pensions go, this one was fairly impactful, unlike many recent Budgets and Fiscal Statements where there was plenty of speculation but not much actual change. Now, however, we have seen announced changes to the annual allowance, the money-purchase annual allowance and the lifetime allowance, so pensions have been very significantly adjusted. Is this a major benefit for scheme members? I decided to analyse the changes announced to pensions in the spring budget 2023.
The annual allowance determines how much someone can save into a pension scheme each year while still benefiting from tax relief. For basic rate taxpayers, this relief means that a contribution of £80 will be “grossed up” to £100 by the scheme reclaiming the £20 basic rate of tax. For a higher or additional rate taxpayer, the additional relief is claimed from HMRC through self assessment, meaning the balance is repaid by deductions from the tax owed for the year in question.
This year, the allowance is set at £40,000. The announcement increased this to £60,000. This basically means that people can pay in 50% more to pension schemes each year without paying an additional annual allowance charge (which is essentially an undoing of the tax relief that would otherwise apply).
In addition to this, there is still the facility to “carry forward” unused allowance for up the three years, so the new limit will ultimately allow up to £240,000 to be paid into a pension in a single tax year.
This is somewhat complicated by the tapering of the annual allowance. I will not go into the specifics of adjusted net income and threshold income (if in doubt, speak with your accountant), but for most people it starts to apply for earnings currently over £240,000 p/a, and it reduces the allowance by £1 for every £2 of earnings in excess of this level down to a collar of £4,000. The Budget today announced an increase of the earnings level to £260,000 p/a and the collar to £10,000, making pension savings much more attractive for the highest earners once more.
Money Purchase Annual Allowance
I have included this as a separate section because it is different enough to the standard Annual Allowance. This regime applies when a defined contribution scheme member starts taking a flexible taxable income. In other words, it does not affect those who have only taken their Pension Commencement Lump Sum (PCLS), those who have bought an annuity, or those who have started receiving a scheme pension. If someone takes even £1 of taxable income under a flexi-access arrangement, then the Money Purchase Annual Allowance applies to them from that moment onward.
Until now, the Money Purchase Annual Allowance has restricted scheme members who have drawn flexible benefits under their pensions to making contributions of only £4,000 while benefiting from tax relief. Anything in excess of that is subject to an annual allowance charge. This Budget announced a change to the Money Purchase Annual Allowance to £10,000.
Importantly, carry forward is not available for anyone subject to the Money Purchase Annual Allowance.
Here is where the Budget completely changed the landscape for pensions going forward. Until now, commencing pensions triggered a test against the “lifetime allowance” and used up a percentage of the prevailing amount each year. When the allowance was fully utilised for a person, any further pension crystallisations would be subject to a lifetime allowance excess charge, which was broadly 25%. In essence, the amount that would have been earmarked for a Pension Commencement Lump Sum within the lifetime allowance would instead be paid to HMRC, but the remaining 75% would be treated identically.
This Budget took the very surprising step of abolishing the lifetime allowance altogether for all pensions from next tax year. However, as we all know, a gift with one hand is often taken away with the other, and the quid pro quo here is that the Pension Commencement Lump Sum is now capped at £268,275 and frozen indefinitely.
In practical terms, this means that immediately – i.e. ignoring the erosion of the real value of this frozen allowance – the position is as follows:
|Assumed Excess||Excess Tax||Effective Excess Tax Rate||Total Effective Tax (higher-rate income tax)|
* This is a consequence of the excess tax charge of 25% compounded with the higher rate tax of 40%. As these are compounded together, the combined rate is 55% rather than the more intuitive 65%.
** In this case, the excess tax is expressed as the additional tax due as a consequence of losing the PCLS. This increases the effective tax rate from 30% to 40%, a difference of 10%.
As such, this is still a benefit for those drawing pension benefits at the higher rate of tax,but it is not as simple as saying that the abolition of the lifetime allowance will be as simple to understand as a
25% tax charge saving.
In addition, freezing the PCLS permanently means that the value of this lump sum will be eroded at the same speed as costs increase. At the moment, inflation is running at some 10%, so that means that the 25% lump sum is likely to be worth only 22.5% in a single year.
This Budget did not make any direct changes to pension death benefits. That doesn’t stop me from talking about it, as there is a huge impact on pensions as a result of this lack of change. At the moment, death benefits are easy when it comes to taxation, in that benefits paid where the member dies before attaining age 75 are free from income tax, while those paid in respect of a member who dies on or after their 75th birthday attract income tax at the recipient’s marginal rate. If the member dies with uncrystallised funds, they are deemed to crystallise on the date of death, so tax of 25% is due on any excess over their remaining lifetime allowance.
As a result of this, pensions are currently viewed as an excellent vehicle for savers. For someone dying before age 75, the income and gains on the enveloped investment portfolios are free of income and capital gains taxes, and the death benefits are then free from any form of tax as well. Post 75 this is a little less powerful, as the death benefits become taxable in the hands of the recipient, but this is still typically better than the 40% inheritance tax rate, especially since it is possible to allow recipients to structure their income so that they receive income at a time convenient to them.
My concern here is that the removal of the lifetime allowance coupled with the freezing of the PCLS will make pensions far better for death benefits and worse for lifetime benefits. Essentially it is turning pensions into an estate planning vehicle rather than just a means of providing efficiently for retirement.
This Budget certainly achieved the main objectives, i.e. making pensions more attractive to late-stage career workers in areas like healthcare. Such people will no doubt be delighted by the changes, as they will be able to work longer, pay more into their pensions and retire when they wish.
The negatives I suspect will be for younger savers. Freezing the PCLS permanently will gradually make lifetime values worse as time passes and inflation continues to rise. A doubling of costs will essentially reduce the value of that 25% lump sum cap to 12.5% of the current lifetime allowance, so young high earners will ultimately have to pay more tax on their pensions than expected.
Finally, I am very concerned over the direction of death benefits for pensions. My worry here is that too much tax is being left on the table – the removal of the lifetime allowance and the lack of change to death benefits means that pensions will become a prime target for any future governments looking to raise funds via a death tax of some sort, and the current regime is just too generous to ignore.
As such, I think it is worth embracing pensions as great savings vehicles for retirement, but on the understanding that there will be more changes under the next government.