Worried about the new pension tax allowance?

[Lima Juliet]

As you all know, the Treasury has announced that, with effect from 6th April 2011, the Annual Allowance that individuals are permitted to increase the value of their pension fund, before incurring an income tax liability, is to be reduced from £255,000 to £50,000 in a given year. Furthermore, the multiplication factor to be used for calculation of income tax liabilities is to be increased from 10 (plus lump sum) to 16 (plus lump sum).

I've worked out how to work this one out now:

(Value of Pension at the end of the Year x 16) - (Value of Pension at the beginning of the Year x 16 x CPI) = annual increase in value

If the difference in value is less than the £50,000 Annual Allowance then you're in the clear - otherwise you will be taxed at 40% of the remainder

Here's a working example for a Lt Cdr/Maj/Sqn Ldr (OF-3) promoted to Cdr/Lt Col/Wg Cdr (OF-4) in 2009 after 18 years of service and how his/her OF-4 pension will fair after the 2 years in substantive rank:

Start 6 Apr 11 as 1 yr OF-4 pension (pro-rata at 50% of between OF-3 to OF-4) is £22k and lump sum of £66k
Value of pension is £22k x 16 = £352k + £66k = £418k x 1.031 (this is CPI) = £431k

Finish 5 Apr 12 as 2 yr OF-4 pension (100%) is £25k and lump sum of £75k
Value of pension is £25k x 16 = £400k + £75k = £475k

Difference between start and end of year on full pension following promotion is £44k - which is less than £50k - which means no Tax Bill :ok:

Also, you can carry forward any unused allowance - so in this example you could carry forward £6k of unused allowance. I understand you can carry forward up to 3 years.

If you want to work out yours the new tri-service pension codes are at Ministry of Defence | About Defence | Corporate Publications | Personnel Publications | Armed Forces Pensions Compensation and Veterans | Pension Codes (http://www.mod.uk/DefenceInternet/AboutDefence/CorporatePublications/PersonnelPublications/Pensions/PensionCodes/)

Panic over, for most of us... :ok:

LJ

PS. I am not a Financial Advisor, so you may want to check out some of my advice, but I believe the calculation is correct.

[thunderbird7]

I think you'll find its more complicated than that ( surprise surprise ).

The x16 factor is applied to the deemed increase in contribution for the year and its the hike in contributions when you get a significant promotion that causes the problem.

[Whenurhappy]

Yes, I am worried. Neither SVPA nor my IFA has been able to agree on my tax liability, indeed even agree on the means of calculation - or how the different offset scheme work. The AG guidance (I've seen nothing from the RAF) is dubious and appears to have errors in it. Its a 'kin shambles.

[JagMate]

Leon, given that your calculation is for an OF-4 with 2 years substantive, are you assuming that the worst year for a promotee is at the 2 year point (ie when you 'earn' the right to your new rank's pension)? If not, does the individual who accepts promotion from OF-3 to OF-4 in this financial year still fall foul of the new regulation change?

Any info gratefully received.

[Al R]

Don't lose sight of the new lifetime allowance either - anyone senior enough and/or moving on to a successful civvy career could be pinged for a sizeable tax bill (contributions over the new £1.5 million limit incur a tax charge of 55%).

When the pay freeze is lifted, there will be up to 1000 officers affected by breaching the annual allowance. A tax liability of <£2000 may be absorbed by taking it out of your gratuity.. final guidance on that has yet to be published.

Whenurhappy, we have Chartered Status - if you need a quick steer drop me a line. I'm with clients most of next week but would be happy to help if I can.

JagMate, the period that is going to affect you is the period that your pension contributions reflect your rank. Have you read the DIN? If you want a hand, drop me a line.

[Always a Sapper]

Me? I'd love to have to worry about that tax bill.... and yes, before someone mentions it, should have done better at school etc etc...

[JagMate]

Please check your pms.

Regards

Jagmate

[Al R]

PM sent back Jagmate – apologies for not seeing them. I was away last week, and some of this. I have replied to you this morning though, and don't hesitate to call me if you need help.

In response to a couple of questions posed via PM about the tax and pensions business, yes - there is lots to be concerned about (especially if you are Air rank), but there is much that can be done to mitigate the impact of these changes. Most of us get swiped by gruesome taxation needlessly, but do nothing about it because we don’t know about it. You might have the best retirement and investment strategy in the world, but if you don’t get your tax planning right, all your hard work could go to waste. So I hope this might be a useful refresher/steer for someone.

For the many higher rate tax payers who will be many reading this after Monday morning prayers, getting your tax planning generally wrong could diminish your returns by 40% or even 50%. Get it right and you can potentially avoid virtually all tax on an investment portfolio. Firstly, hopefully all Pruners will have maximised their ISA allowances and made use of pensions where appropriate for their wife/husband/civil partner and considered the new Junior ISA as a platform for funding education needs in the future. But that’s not all that can be done and as the basis of that premise, we need to remember that not all investments are created equal (or rather, not all investments are taxed the same).

Income from shares, investment trusts, equity or property based unit trusts, is taxed as dividends. That means, that if you are a basic rate tax payer, you have no tax to pay as the notional 10% tax credit covers your liability, so well done to most Flying Officers, Flt Lts and Sgts/CTs. Higher rate tax payers however, have to pay 32.5% or 42.5%, but again the 10% credit is offset against it, so the tax charge is going to be a little bit less. Non tax payers cannot reclaim this so this makes them a poor option for a non tax paying wife/husband etc who might be ‘just’ raising the children in the MQ. Income from corporate bonds, gilts and fixed interest funds however, is taxed as interest just like cash is (I hope that Form R85 has been submitted for non taxi paying savings accounts holders!). Both different criteria may be handled differently for different people, to different effect. Ultimately, a little bit of canny planning should be able to wipe out the impact of the new allowance which will hit most readers, via their AFPS contributions.

Many investments are also subject to capital gains tax (CGT) which in the simplest of terms is a tax on profit. However, the first £10,600 of capital gains you make are tax free.. which is nice and makes it, in effect, a Stocks and Shares ISA supplement. This is a pretty generous allowance and usually more than adequate for most RAF clients that I see, but it is often ignored. To use it and to make the best use of it, you need to be flexible and consider crystallising a gain by selling some investments. That might be contrary to considered ‘best’ practice, but all clients have different needs and there is never one size fits all. If you don’t use this annual allowance, you lose it.. simple. You cannot carry it forward like you can do (currently) previous unused pension allowance. If you don’t use it and if you allow applicable investments to accrue large gains, then when you encash them without much thought, your pension tax charge for many (the DIN I saw, reckons on up to 1000 officers when the pay freeze is lifted) might seem tame by comparison.

If you are anticipating large gains or is considering investing a large sum of cash for the future, such as a redundancy settlement, then it might be that the first part of that amount (outside your ISA of course), is often best held directly. It should then be part of your annual review process to consider selling part of that investment annually as part of a CGT tactic, and switching the amount into an ISA/pension/VCT/IES etc. For many clients, this is a useful course of action to consider for any investment of say, £200,000 which might incur a covert CGT charge 20 years or so down the line, at the time of liquidation/encashment. Another course of action might be to consider investment bonds, which have had a bit of a bad reputation for two reasons. Firstly, the CGT rules were changed a couple of years ago which made bonds look less attractive by comparison and secondly, for many years they were shady products sold aggressively with high charges to match that clobbered performance and return. Nevertheless, if used correctly and in the right way and in the right amounts, they can be very helpful. They can be complicated but in summary, there are two types, onshore and offshore and both are subject to income tax, not CGT. That is important, for reasons which might become clearer if you haven’t already fallen asleep.

Offshore bonds contrary to perception, are marginally simpler. During the life of an offshore bond, there is no tax (except for some withholding taxes) which allows gross roll up of profits and gains and you simply defer tax until you encash all or part of the bond, if you do nothing within the life of that investment. If interest can be received gross, it usually makes a big difference to compound gains in the long term and it also usually makes sense to recommend a mix of different asset classes for all investment portfolios (most ‘normal’ clients will have some money in equity, property and fixed interest (government/corporate bonds) with equity growth assets held directly in order to use the CGT allowance. Most switched on IFAs will often hold fixed interest assets via an offshore bond for that compounding effect, if they know your needs.

That’s all well and good when the bond is still growing, but if the investor is a higher rate tax payer when the bond is encashed, he/she may have to pay 40% tax on the gain, which is not good. Fortunately, there are some useful techniques that can be used, such as assigning to a basic or non tax paying wife/husband/civil partner before selling, or staggering a sale over more than one tax year. An onshore bond is similar, but some tax is payable during the life of the bond instead. An onshore bond can work well for equity income or property fund investments if returns come largely from dividends and there is no tax within the bond on dividends, other than the 10% tax credit. These investments also make capital gains, but generally less than pure growth assets. Tax is paid on gains within the bond every year, but only when that year’s gain is higher than inflation. If the gain if less than RPI, there is no tax. If RPI is 5% and the gain is 6%, then just 1% is subject to tax.

This means that equity income or property investments can roll up tax efficiently within an onshore bond. If held directly, a higher rate tax payer would have had to pay tax on those dividends as they went along. When sold, an onshore bond offers no further tax for a basic rate tax payer and Higher rate tax payers will have to pay 20%. However, tax planning techniques mean that you can often avoid higher rate liability.
So, as I have often said, be concerned about your military pension, but don’t get target fixation. There is much, much more which may be done to offset the impact of any swingeing pension tax contributions – even if you aren’t anticipating a charge, there is much that may be done to chip away at that tax charge, which can have a huge impact on the performance of your investments, due to the compounding effect of not paying (so much) tax.

In essence, don’t ignore tax planning and understand the tax implications of any investment that you buy. If you can keep the right assets within the right tax wrapper, the benefit can be huge. Get it wrong, and you can destroy a large part of your gains that will make the AFPS tax issue seem tame. As ever, please feel free to drop me a line if you want information – (can't/won't offer advice on messageboards and by PM due to a justifiably strict FSA compliancy regime) but I’m happy to help where I can and provide a steer to where you might get advice, but if in any doubt, you should generally seek advice from your bank or IFA. Finally, this post is made on my uderstanding of the current tax system and it may of course, change. Not all investments are suitable for all clients and investments can lose money. Phew.

[AV8tour]

AL R - thanks for v informative post.

One question - how does the Standard LTA get calculated on the P60 from Xafinity paymaster? I've searched previous posts and none of the calculations suggested come close to the figure given on my P60 - which is 91.32%.

How is this % figure derived?

FYI, Rtd as OF5 in Jan 08, AFPS05, 24yrs service.

Thanks,

Bill

[Al R]

Bill,

I've done a fag packet calculation and estimate that you've used about a fifth of your lifetime allowance, certainly nowhere near 92%. Lets assume that we work to the new (current) LTA (£1.5 millions) and not the old one (£1.8 millions).

91% of 1500000 = 1365000

As your pension is in payment, that figure is then divided by 20 which gives us £68250. However, instead of receiving an annual pension of £68250, I assume that your annual pension in payment is somewhere in the region of low/mid 20s, so your LTA% should only be about 20% used. Without digging deeper, the only thing I can assume is that you haven't filtered an inheritance of a million quid or so into another pension over the years and forgotten about it?! A couple of clients have had snags with their AFPS payments in May though, so a call to Paymaster on 0845 1212 514 (#3) requesting a LTA percentage calculation might help. I'd be interested to know what they say..

You raise a good point about the new Lifetime Allowance (LTA). Although not exclusively an 'Airship' problem, 2/3* (for instance) are certainly going to be creating significant taxation problems for themselves with the revised LTA if they do nothing, and that doesn't even take into account pension fund growth via a concurrent private and/or second civvy career. If they don't expect a pension in accumulation to grow (or by more than CPI), they should consider taking advice about declaring 'Protection' from HMRC and considering other retirement planning options. They only have limited time in which to do that. The taxation rate is 55% (55) of all accumulated contributions into a fund that nominally is worth more than £1,500,000.

[Melchett01]

I may have got the wrong end of the stick here, but I was wombling through the MOD Benefits Calculator the other day and noticed a comment about pension contributions made by the govt to our scheme being based on SCAPE rates.

Now when I look through the paperwork for the new pensions / tax liabilities, I see that the calculations used to calculate how much our pension has increased by annually - and therefore if an individual has a tax liability - are based on the amount we receive each year.

So the million dollar questions:

1. What exactly are SCAPE rates? I looked it up and frankly what documentation I could find may as well have been written in Swahili.

2. What is the difference between the govt's annual pension contribution based on SCAPE rates at the front end, and what we receive and will have our tax liabilities levied against at our end of the chain? Where can we independently check this out ourselves in a manner that actually makes sense to your average Blue Suiter?

3. Am I being cynical to think that the 2 rates might be different and that the individual will end up being disadvantaged tax-wise if our annual pension payments are far in excess of the actual value of the SCAPE rates? (And yes I see this question getting replies on the lines of that's why your pension is unsustainable!)

[Al R]

Superannuation Contributions Adjusted for Past Experience (SCAPE) methodology is required because the public sector needs to be able to project ahead and budget accordingly for future needs 60 years or so down the line. Unlike a civvy Defined Benefit Scheme, public service pension schemes do not have a tangible fund of assets from which pension benefits are paid. Instead 'our' benefits are paid out of ongoing tax revenue (our kids, in other words) and the fact that the Exchequer ultimately stands behind that promise does not change one thing - the amount still has to be funded from somewhere. And to do that, a level or notional level of employee contribution has to be established, which depends on a rate, which is 'set' and then discounted according to circumstances at the time.

As one of many factors, the amount determined by what you are paying (abatement) now for older servicemen's mil pension and what you in turn, will receive in the future determines the discounted rate at which your 'virtual' pension fund grows. Its a notional fund/contribution, but it is generally believed that the current discount rate is at the high end of what is appropriate and that it should be reviewed (ie; reviewed upwards). The 4 largest public sector schemes have already introduced reforms (Civil Service, Teachers, NHS and Local Government) which were intended to limit taxpayer exposure to the rising cost of providing pensions (inflation/higher costs of living/better life expectancy etc).

SCAPE certainly has an impact on things such as CETVs which are used in divorce cases etc. However, the crux of your point relates to the point of taxing and contribution limits? A change in discount rate would (in principle) affect the value placed on the (Big 4) pension benefits accrued relating to past service but the G'ment has decided that it is not appropriate for this to be reflected in future contribution rates as a result of any change in the discount rate. However, who knows what tomorrow will bring..?! The Consultation was aired last December, so here's a little light reading (I haven't seen the outcomes of it yet).

http://www.hm-treasury.gov.uk/d/consult_unfunded_pension_condoc.pdf (http://www.hm-treasury.gov.uk/d/consult_unfunded_pension_condoc.pdf)

[AV8tour]

Will contact paymaster and let you know outcome.

[AV8tour]

Paymaster have agreed LTA figure is in error and should be IRO 20% as you indicated - thanks for info etc.

BTW, spoke to Glasgow as well and asked for a reassessment of my 'final salary' figure for AFPS 05 calculations - I had received substitution pay (SPA) for 7 months in my last year of service (carried out Gp Capt duties) and was not convinced that this been taken into account for the 'final salary' calculation - Glasgow contacted me yesterday saying my pension figure was indeed in error and will be readjusted upwards accordingly! Glasgow staff were very receptive to dealing with my enquiry and timely in their response - good on them!

[Al R]

Thanks Bill, and a good result.