Work-arounds to new tax relief cap

As the Treasury reveals that it has no plans to change the proposed tax relief restrictions on pension contributions for higher earning contractors, advisers have discovered a work around for certain income brackets. Tony Harris, IFA from UKTECH's 'Ask an Expert' page, explains that for those contractors who enjoy earnings in excess of £150,000 per annum the news that there will be restrictions on pension tax relief has been a blow.

Tony Harris writes:

Tony Harris Many thousands of contractors have used the pensions simplification rules, introduced in 2006, to good effect and have significantly reduced their tax bills. The virtually unlimited scope to make 'employer' contributions up to an annual £245k has been a very effective tax planning tool and as pension advisers we have estimated that our clients alone will have collectively saved tens of millions of pounds that would otherwise have gone to the Exchequer.

Unfortunately we've recently seen this simplification regime begin to unravel and despite widespread opposition to the proposal, the Treasury announced recently that they have no plans to withdraw the proposals to cap tax relief on a mere £20k of contributions. Instead they plan to drive through the new rules so that they will become entrenched by April 2011.

Special Annual Allowance

To prevent a 'closing down sale' of investors trying to exploit the current rules whilst you still can the authorities have brought in an interim restriction.

If you expect to receive an income (salary and dividends but also any rental and investment income etc) in excess of £150k pa in 09/10 or have enjoyed such earnings in the past two years, then instead of an annual pensions contribution allowance of £245k pa there is now a special annual allowance that applies which will cap what you and your company can invest on your behalf.

The only piece of good news was that higher earners who were making regular pension investments prior to April 22 2009 will still be allowed to continue investing at their current level, irrespective of whether this is in excess of £20k.

We have looked at the impact for various earnings brackets and advise on the future planning required.

Contractors earning over £170k

You do fall foul of the new restrictions and the annual allowance is dramatically reduced to just £20k pa. Investments in excess of this level will still be possible but you personally will have to repay the equivalent of high rate tax relief on any pension contribution made by you or on your behalf (i.e. even if your company made the initial investment on your behalf). This reclaim of the 20 per cent tax relief will be via your self assessment.

We would advise that you seriously consider setting in motion a regular investment for the new trading year to not only maximise the reduced tax break still available but hopefully also to safeguard the right to continue contributions should the rules change again.

The reason for this recommendation is as a result of the fact that when HMRC brought in the new £20k pa cap they specifically exempted from the new rules any pre-existing regular pension investment (made on at least a quarterly basis before April 22). We have existing clients investing in excess of £20k per month who followed our advice to 'drip feed' their contributions and to whom the new rules have had no impact whatsoever. It could be likely that any future restrictions could also exempt existing contribution levels.

Between £170k and £150k

If you are borderline in terms of breaching this income threshold (earning or having earned between £150k and £170k pa) then we have found a work around to the new rules. By salary/dividend sacrificing £20k of your income you then fall below the £150k threshold which then opens the gates to far more substantial investment.

This work-around only applies specifically to this income bracket as the £20k cap means that higher earners cannot exploit this quirk of the rules.

Similarly gift aid can be used to reduce the previous tax year's earnings below the £150k level.

Under £150k

If you fall under the £150k earnings figure then the new cap does not apply and you should be free to invest as planned but we would advise that you seriously consider setting in motion a regular investment for the new trading year.

With the hole in the public finances growing ever wider there is real concern that further pension changes could be forced through in future budgets. Setting up a regular contribution now could, as we have seen with these recent changes, potentially protect your ability to continue exploiting the tax breaks even after any future restrictions.

Tony Harris is Managing Director of ContractorFinancials an Independent Financial Advisers that specialises in offering financial solutions tailored to your Contractor status. To speak to one of their experienced pensions advisers call 0845 062 8888, quoting "UKTECH" or fill in the online enquiry form here.