This year's budget was a fairly low key event as the most significant change - to tax and national insurance - was announced a year ago when Gordon Brown was Chancellor. The headline grabbing announcements this year were tax increases for those who smoke, drive cars or drink alcohol. While pensions didn't make the headlines, beneath the surface there were several changes which do have a significant impact.
A positive change allows people to take very small benefits from occupational pension schemes as a lump sum. The new rules look at one scheme in isolation and allow benefits to be paid as a lump sum where the value is below £2,000.
The trivial commutation rules introduced on 6 April 2006 allow people who have small pension pots to take the whole lot as a cash lump sum. 25% of the lump sum is tax-free with the remainder being taxed as income. Benefits can be taken under the triviality rules if the total value of an individuals pension benefits are less than 1% of the lifetime allowance (£16,500 in 2008/09).
Because this rule looks across all pension pots belonging to one person, it means that someone can be left with a very small amount in one scheme. For example if someone has a final salary benefit worth £15,000, and benefits in an occupational defined contribution scheme worth £2,000 then, in total, the benefits are above the trivial commutation threshold. The defined contribution scheme is likely to pay 25% (£500) as a tax free lump sum, leaving the individual to buy an annuity with £1,500. As this is below the minimum annuity purchase price of most providers, it is likely the person will be stuck with their current pension provider, receiving a very small amount.
The budget changes allow people to take very small benefits in one occupational scheme, which are worth less than £2,000, as a lump sum while receiving an income from another, larger, pension pot.
Forcing people to buy annuities with very small pension pots means they don't receive good value for money. So allowing small pension pots to be paid as a lump sum even though the individual may be receiving income from another, larger, pension is a positive step. But it is very disappointing that the Government has restricted this change to small occupational schemes. The same issues and problems arise for those who have small personal or stakeholder pots.
The budget also confirmed the closure of a loophole which allowed pension funds to be passed on tax-free at death. Providers of small self-administered pension schemes (SSAS) have been marketing scheme pensions as a way of passing pension money onto family free of tax since A-Day. However, the Treasury has clamped down on what it regards as an abuse of the rules. This change was expected and, from the Government's perspective, is a logical step which brings scheme pensions into line with alternatively secured pension. But from a wider viewpoint, the tax rate of 82% applied to inheritances under both routes is unnecessarily punitive and will not do anything to encourage more pension savings.
A much simpler solution would have seen the Government levy a flat rate tax charge of, say, 40% on pension funds passed onto children. In one fell swoop the Government would have raised a lot more revenue and, by having a single rate of tax, there would have been a simple understandable system. And all without the anguish inflicted upon people who simply want to pass some of their hard earned savings onto their kids.
The changes to tax and national insurance (NI) announced last year also have an impact on pensions. The changes abolish the 10% starting rate of income tax for earned income and pensions. So the first slice of people's taxable income is taxed at the basic rate. This means people pay £223 each year more in tax on this first slice. But the basic rate of income tax has fallen by 2p in the pound, to give a new rate of 20%.
At the same time, some substantial changes have been made to NI. The ceiling for paying the standard 11% rate of NI contributions has risen quite sharply - by £3,900 over and above the normal inflation-linked increase. That means that the main NI rate now applies to income up to £40,040 a year, rather than £34,840 in 2007/08. NI will again increase above inflation from April 2009 as the thresholds for income tax and NI merge.
As the following graph shows, those earning £15,000 a year or less are likely to be worse off. By having more of their income taxed at 20%, rather than 10%, they pay more in tax. For example, someone earning £8,000 is around £12 per month worse off.
The biggest winners as a result of these changes are those earning about £35,000 a year who take home around £32 per month more. They save income tax yet pay no more NI. However the rise in the ceiling for the standard 11% NI contribution rate means that those earning about £40,000 a year gain very little, as they now pay the higher rate of NI on more of their income.
These changes impact upon the payments people make to personal and stakeholder pensions. Before April, if people wanted £1,000 in their pension, they had to pay £780 as the Government added £220 in tax relief. Now people need to pay £800 as tax relief is only £200. As a result of these NI changes, now is a good time to reconsider the benefits of salary sacrifice – particularly for those earning between £35,000 and £40,000 a year. Salary sacrifice means taking a pay cut, or giving up bonus payments, in return for an alternative non-cash benefit – such as an employer pension contribution. Because NI is saved on the cash payment given up, the alternative pension contribution can be increased at no cost to the employer or individual. This is most effective where the income sacrificed is below the upper NI threshold, as this gives an 11% NI saving for the individual (compared to 1% on earnings above this level).
Case Study
Bob has a gross salary of £40,000 in 2008/09. The following table shows his income with and without salary sacrifice based on the new income tax and NI rates. The example assumes the employer is willing to add their NI saving to the pension contribution.
| No salary sacrifice | With salary sacrifice | |
| Gross salary | £40,000 | £35,826.09 |
| Income tax | £6,913 | £6,078.22 |
| National Insurance | £3,799.40 | £3,340.27 |
| Cost to individual of personal pension contribution | £2,880.00 | £0 |
| Take home pay | £26,407.60 | £26,407.60 |
| Gross monthly pension contribution | £300.00 | £392.34 |
In summary, by taking a cut in gross salary of slightly over £4,000 a year, Bob maintains the same take home pay and benefits from an increase of over 30% in his pension contribution at no cost to him or his employer.
As the name suggests, salary is being genuinely sacrificed therefore any benefits which are based on salary may be affected, for example a mortgage or credit card. In addition some State benefits are linked to earnings so may be affected.
The tax and NI changes which took effect from 6 April mean that some people gain a little and some people lose a little. The changes simplify the number of rates and bands rather than cut tax bills. But they do substantially increase the tax benefits, for some people, of using salary and bonus sacrifice. There are some pitfalls and care needs to be taken to ensure that those who opt for salary sacrifice know how it affects them and are able to make an informed decision.
Looking at the other pension related changes in the budget, it is unfortunate the Government seems focussed on stopping perceived abuse rather than encouraging people to save for their retirement. The Government deserves credit for allowing people with very small occupational pots to take this money as a lump sum. But people who have very small personal or stakeholder pension pots should be able to do exactly the same. Two years ago, the Government's much heralded pensions simplification legislation introduced the same tax rules for occupational and personal pension schemes. Reversing this move such a short time later, to the detriment of people who have small pension savings, is an unwelcome and retrograde step.
Andrew Tully
Senior Pensions Policy Manager
Tax and legislation are liable to change. This information is based on Standard Life's current understanding of law and HM Revenue & Customs practice.
Tax rates and reliefs may be altered. The value of tax reliefs to the investor depends on their financial circumstances. No guarantees are given regarding the effectiveness of any arrangements entered into on the basis of these comments.
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