I am fortunate enough to be well paid as a director of a hotel company, and I am hoping to receive a bonus next year. However, I have inadequate pension provision, as I have only contributed small one-off amounts into my personal pension in the past few years. I'd like to pay my bonus into a pension, but I gather there are new rules, which have left me very confused. How much can I pay in without suffering a tax charge?
The tax rules on pension contributions have become particularly complicated since April 2009. The Labour government announced that there was to be a restriction on higher rate tax relief from April 2011 and, to prevent people contributing large amounts into pensions before the restriction came into force, complex ‘anti-forestalling rules' were introduced. These rules apply for the 2009/10 and 2010/11 tax years to anyone whose taxable income is £130,000 or more. For most such high earners the maximum pension contribution that can be paid and will gain full tax relief is £20,000.
The coalition Government announced that it would not follow Labour's policy on higher rate tax relief. Instead, in October 2010 it published draft new legislation which, from April 2011, will allow pension contributions of up to £50,000 a year, without any restriction on tax relief.
It will be possible to exceed £50,000 if there was unused capacity in the previous three tax years. If the limit, plus brought forward capacity, is exceeded there will be no tax relief on the excess for personal pension contributions. If contributions are paid by the employer, any excess will be treated as taxable income for the employee.
In the context of a bonus, it may well be desirable for the employer to pay the bonus direct into a pension. If properly structured, such ‘salary sacrifice' arrangements can save the employer from having to pay National Insurance contributions, currently payable at 12.8%. Many employers will use the NIC saving to top up the amount paid into pension.
On the assumption that the director has taxable income of over £130,000 in the current tax year, he is recommended to limit pension contributions (whether personal or from his employer) to a maximum of £20,000 in the current tax year ending on 5 April 2011.
From 6 April 2011 the new rules will apply. Say, for example, that the director's only pension contributions in the three previous tax years were one-off payments of £5,000 each year. He would have unused capacity of £45,000 for each year, a total of £135,000.
Adding that to the new £50,000 annual limit means that a pension payment of up to £185,000 could be made in the 2011/12 tax year without adverse tax consequences.
Because of the NIC savings that result from pension contributions being made by the employer, the director should consider whether his bonus next year could be ‘sacrificed' in favour of an employer pension contribution.
If the employer contributed £100,000, and that was the only 2011/12 pension contribution, it would be possible to contribute up to £135,000 in 2012/13.
â- Consider making one-off large pension contributions only after 5 April 2011
â- Agree with the employing company whether pension contributions can be made by the employer
The new pension legislation is only in draft form at the moment, and might change by April 2011. Seek advice at the time from a tax accountant or IFA before making large pension contributions.
Chris Lee is a tax partner at James Cowper LLP