Freelancers' guide to new pensions regime

Today (April 6) is pensions A-day - the day the numerous tax rules governing pensions are replaced by a single regime. Tony Harris of ContractorFinancials explains what this means for freelancers.

Tony Harris of ContractorFinancials writes:

The Finance Act 2004/5 contains proposals to simplify pension legislation. As of today (April 6 2006, known as A day), these proposals will take effect. The changes could be relevant to your future whether you are just starting your career as a contractor or you are a freelance specialist about to retire.

A Day (Appointed day) brings with it many changes for contractors. There will be far more flexibility as to how you access existing pension holdings and big changes to the rules surrounding ongoing investments, whether made via an employer contribution from a one-man limited company or personally from private funds.

After this date the set of eight current pension regimes will be updated to just one set of tax rules for all types of pension, with an individual Lifetime Allowance (£1.5 million 2006/2007). This lifetime limit will rise by preset amounts for the next five years and looks likely to be increased beyond this date.

This amount is so far in advance of what many freelancers would currently have built up in pensions that I have chosen to ignore the issues facing those who are close to this lifetime limit.

Contribution Levels after A day

How much can I contribute?

Given the substantial tax breaks associated with pension investment, a fundamental question that clients ask is how much they can invest in a given tax year.

Unlike the current restrictive rules that limit pension investment to a set percentage of salary, the new regime will allow contractors to personally contribute 100 per cent of salary. In addition the rules regarding funding a pension scheme direct from your limited company appear to allow a massive employer contribution of up to £215k pa irrespective of salary which would mean that, in effect, the only limiting factor on a contractor's investment would be the resources physically at your disposal.

Pension by postcode?

Financial planners and investors greeted the promise of virtually unlimited employer contributions with great enthusiasm but as the mechanics of how the new rules will work in practice become clear it now appears as if this new freedom could, in reality, be difficult to exploit.

For a substantial 'employer' contribution to be allowable for tax relief, the final authorisation will potentially lie with the Local Inspector of Taxes, which implies that the new rules could trigger unwelcome interest from the taxman into a contractor's financial affairs. Clearly a situation where contributions are decided by the largesse of the local tax office could result in different allowable contributions depending on where an investor's tax affairs are handled. Ironically the current restrictive, yet clear-cut percentage based rules may be giving way to a system that allows more scope to invest in theory but with less certainty in practice.

Solutions post A-day

It appears that personal contributions, from a private bank account, will not attract the attention of the tax authorities to anything like the extent that a substantial employer contribution will. Compared to the age related maximum contribution (17.5 per cent to 40 per cent of salary) that currently applies, the new 100 per cent limit will offer scope for many freelancers to increase contributions.

On the negative side, the 'carry-back' rules, which currently allow contributions to be classed as having been made in the previous tax year, were removed for most investors on January 31. Freelancers also have only a very short time to make use of any higher salary from a previous tax year under the 'basis year' rule that will also disappear this April.

This second rule has been widely exploited by investors who are now on tax efficient low salaries yet can invest substantial amounts based on a previously inflated salary (perhaps a legacy of a spell as a permie or time spent within IR35).

Ongoing employer contributions could prove more problematical and it could be some months before we have a clearer understanding of how the new freedoms will be policed. It seems likely that contributions made under the existing regime would help ensure that any subsequent employer contribution is viewed more favourably, pointing to the need to maximise this year's scope to invest.

Full concurrency and investment flexibility

Full concurrency will mean that investors will be able to pay into any array of plans, as opposed to the current arrangements where many occupational pension holders and controlling directors are unable to enhance benefits with a personal/stakeholder pension. There will be greater investment flexibility i.e. collective investments into property (although not directly into residential bricks and mortar as originally planned when A day was first announced).

Taking your pension benefits after A Day

The new regime allows you to take 25 per cent of all pension arrangements as a tax-free lump sum. For the first time this will include funds from protected pension funds such as those that relate to contracting out of SERPS (the state earnings related pensions) and its replacement S2P (state second pension). You will also be able to take 25 per cent of AVCs and FSAVCs (free standing additional voluntary contributions) as tax-free cash.

The new rules will allow you to take non lump sum pension benefits in one of four ways:

• 1) Scheme Pension Payments - as now, an income can be paid directly from the pension scheme. This kind of pension is usually paid from certain types of large company pension schemes.
  
• 2) Lifetime Annuity Payments - as per the current regime, your pension fund can be used to buy an annuity from an insurance company. The annuity is guaranteed to pay you a regular income for the rest of your life and may also include a pension for your spouse/dependants when you die.
  
• 3) Unsecured Pension – this is the type of arrangement that will suit those who don't wish to use their fund to purchase a rigid annuity. Your fund can remain invested and you can elect to simply take an income, if required, from the fund. Currently it is compulsory that you take at least a minimum level of income but after A-day you will not have to do so and can allow the growth to accumulate. This type of arrangement is only available until age 75.
  
• 4) Alternatively secured pension – this is similar to an unsecured pension but is only available after you exceed age 75. Unlike the current rules, which state that you must 'secure' benefits with a rigid annuity, it will be possible to leave the money invested and an income can simply be withdrawn from the fund.

Retirement Age

From April 6, 2010, there will be an increase in the minimum age at which you can draw benefits from 50 to 55. Although there are certain exemptions to the age that pension benefits can be taken, there will be none for contractors in personal pensions (including stakeholder pensions), which currently permit retirement from age 50 onwards.

Trivial pensions

If the total value of all of your pension plans is £15,000 or less at or after April 6 2006 then you may be able to take this as a lump sum. Twenty five per cent of the lump sum will be tax-free with the remainder being taxed as earned income. You should review all your pension plans and calculate their total value.

Death Benefits

The existing regulations restrict life cover benefits but under pensions simplification the maximum death benefit that a contractor's family can receive is £1.5 million i.e. the Lifetime Allowance. Any excess paid as a cash lump sum over this amount will be subject to the 55 per cent lifetime allowance charge payable by your family or beneficiaries. However if this excess is used to provide an annuity for your beneficiaries then this charge will not apply.

This added scope to fund your life insurance requirements via a pension will mean that contractors will be able to benefit from tax relief on Pension Term Assurance and this change of heart by the taxman could spark a major review of existing life cover with the prospect of over 40 per cent tax relief on contributions for some investors.

In Summary

It is important to understand that, even at this late stage, some of the implementation of these new rules is not yet fully finalised and there may well be further changes to the proposed legislation. However, it does seem fair to state that pension investment will allow far more freedom in future, with greater possibilities for tax savings, enabling contractors to build a better nest egg towards a prosperous retirement. At a time when the rest of the country looks to be sleep walking into a retirement funding abyss caused by longevity and low birth rate the message seems clear, that it is down to us as individuals to provide for our own futures as the state is increasingly unable to do so. At long last the authorities seem to be going some way to giving contractors the tools with which to provide for that future.

Tony Harris

ContractorFinancials