Pension schemes explained and common tax planning

When I hear the word ‘pension’ I instinctively think of the older and wiser generation with large sums of money tucked away for future use. But what more is there to the pension schemes and options available? Below I will briefly explain some of the details and tax savings that can be had, if and when the time is right for you.

Essentially there are three phases. Contributions are made into an individual’s pension fund, and the monies in the fund are invested in assets. A few years pass and the benefits are accessed from the pension fund upon retirement.

The more common pension schemes used are personal schemes, run by a pension provider and open to any individual to join. Tax relief is available on an individual’s contributions in the form of ‘relief at source’ where HMRC gross up the contribution (pay in an extra 20%). The individual’s income tax bands are then extended by the amount of the grossed-up contribution. This saves an extra 20/25% of tax for higher/additional rate taxpayers. Of course, this is subject to the maximum amount of annual tax relievable contributions, which is the higher of £3,600 and relevant earnings (employment income and trading profits). For employers, the contributions are exempt benefits for the employee and the contributions are deductible from the trading profits of the employer.

An occupational pension scheme is run by an employer for a group of employees. It is much the same, the only difference being the effect on the relief for the employee. That is, the pension contribution is deducted from the employee’s income, before income tax is calculated. This is called the net pay arrangement.

A point to note is that there is an annual allowance of £40,000 per individual. This is restricted once the individual is earning more than £240,000. The limit on the contribution in one year is the current year annual allowance plus any unused annual allowance from the prior three years.

Of course, on retirement, when the funds are vested, HMRC catch up with the tax savings that have been had. Depending on whether the funds are vested as a lump sum or a pension income in the form of an annuity, the funds are taxed as non-savings income at the standard rates. The lifetime allowance for drawdown is £1,073,100, and if the funds are vested as a lump sum, 25% of the fund value can be taken tax free.

So, what are the main tax planning advantages?
There is an opportunity for small owner-managed businesses to make their own investment decisions and hive down on a tax planning opportunity, particularly when investing in commercial property.

The shareholders decide to invest in a commercial property, a warehouse or factory. The company is required to make a contribution into the pension scheme in order to provide finance for the investment. This is a tax-deductible expense for the company, thus saving a large amount of corporation tax and is exempt from tax for the fund. As mentioned above, there is an annual limit to the contribution, however, this can be multiplied depending on the number of shareholders in the company and the contributions they have made in the prior 3 years.

The fund then purchases the building, for the company to use. As a result, the company pays rent for the use of the property at market value. This is exempt income for the fund and reduces taxable profits for the company. This continues to reduce tax and will become more attractive when the tax rate increases. It is important that you consider the effects on your balance sheet of this action.

Pension funds are also exempt from capital gains tax, so any gain on eventual sale of the building by the fund is exempt.

It is important that all factors are considered; the cash in hand, the effect on the company’s balance sheet etc, the administrative burden of the pension fund, not only the tax savings in isolation. For more information get in touch.