Contractors would be wise to proceed with caution as the dust has begun to settle on the Budget’s announcement that higher rate tax relief will be capped on pension contributions. Tony Harris of independent financial advisers ContractorMoney explains why. (Source: Contractor UK)

“Canny investors have dramatically reduced their tax bills over the past three years thanks changes in 2006 to pension contribution limits. The so called ‘A-Day’ pensions simplification rules effectively allowed contractors to invest what they chose to, and unlike the previous pensions regime that demanded a large and tax inefficient supporting salary, the only cap to employer contributions were annual and lifetime allowances (currently £245,000 and £1.75 million respectively).

“Those on higher incomes had the greatest scope to exploit the new pension freedoms and the result was the 1.5 per cent of top earners were able to legitimately use the rules to the extent that they received 25 per cent of all pension tax relief.

“With a new 45 per cent top rate of income tax in the pipeline, the announcement early in the Budget speech that this was to be revised up to 50 per cent, and brought forward by a year, seemed to play right into the hands of even greater emphasis on pension planning as a means to reduce the impact of tax rises. But within minutes the game was up.

“Sadly the Chancellor went on in his speech to say that he was calling time on such effective use of the pension rules and announced that from April 2011, anyone earning over £180,000 will see their tax relief restricted to the basic rate of 20 per cent. Those earning between £150,000 and £180,000 will qualify for relief on a sliding rate between 40 and 20 per cent.

“As soon as this announcement was made, minds turned to how high earners could maximise their pension contributions over the next two years to exploit the existing freedoms before they were lost. However we soon learned that complicated “anti-forestalling” rules will prevent what would otherwise have been a closing down sale for investors.

“Restrictions for those who will have earned £150,000 a year or more in the current or two previous tax years mean that those affected will have tax relief restricted to 20 per cent on pension contributions above a new ‘special annual allowance’ of £20,000.

“This new annual limit applies to the total of both employer and employee contributions. Therefore our hopes of continuing to using unlimited company contributions for limited company contractors or, for umbrella company users, salary sacrifice arrangements, to circumvent the new rules were also dashed.

“So how do contractors live with the new pensions regime?

“Much of how the new regime will look like in practice is still sketchy but it is clear that we are in the bizarre situation that any contractor earning £149,999 a year can invest virtually all of that sum into a pension without corporation tax, income tax, NI or benefit in kind considerations, whereas a contractor who earns just £1 more can only invest the special annual allowance of £20,000. Any investment over this £20,000 threshold will trigger a repayment of the balance between the deemed basic and higher rate tax relief on any excess investment over this new annual limit. This tax relief reclaim is likely to be via the self-assessment return.

“The £150,000 a year earnings figure does not simply apply to salary but also includes, amongst others, dividend income, bank interest and rental from buy-to-lets.

“One piece of good news is that existing investors who are paying more than the £20,000 limit will still be allowed to fully exploit their current arrangements as long as they were investing regular monthly or quarterly contributions before April 22nd. However it could be crucially important that they do not interrupt these regular contributions.

“Unfortunately this pre-existing contribution ‘get out of jail free card’ will not include those who preferred to wait until company year-end each year before investing a lump sum. Sadly such ad hoc payments are not deemed to be pre-existing regular contributions.

“These pre-existing regular pension investments are to be known as “protected input amounts”. For example, someone already investing £2,500 a month can continue to do so and benefit from the full 40 per cent tax relief on the amount.

“Contributions that exceed the special annual allowance or protected input amount will be restricted by applying a special annual allowance charge of 20 per cent this year, rising to 30 per cent when the top rate of income tax goes up to 50 per cent in April 2010.

“It may now be the time for contractors who are in the fortunate position that they narrowly miss the £150,000 earnings cap to maximise regular contributions ahead of any future increase in earnings or a further tightening of the rules. As we have seen, pre-existing regular contribution levels have attracted various concessions.

“For those above the £150,000 limit this year or who have earned in excess of this amount over the past 2 years, it could be argued that it is now even more important that they invest up to that new £20,000 annual limit to exploit what is one of the few remaining tax planning avenues left.

“Of that £20,000 investment towards your future income in retirement, the taxman is, in effect, paying £8,000, which is not a bad immediate return on your net investment. It could also be said that your cash is hitting the markets at what many consider to be a once in a lifetime buying opportunity to accumulate assets on the cheap.

“For the vast majority of pension investors and advisers there was a sense that it could have been a lot worse. Gordon Brown had hinted that high rate tax relief could be abolished altogether. But in a classic example of political manoeuvring many now feel relieved that it was only top earners who are affected by the announcements.

“In reality though, abolishing higher rate tax relief was never realistic given this government’s desperate need to encourage private provision ahead of a looming disaster for state pension provision, caused by a projections of a shrinking workforce and increasing longevity.”

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