Now that the Finance Act 2009 has received Royal Assent, there are three key areas in relation to income tax and pensions that need to be understood and planned for:

• Pension contributions in 2009/10 and 2010/11
• Income tax planning from 2010/11 onwards
• Pension contributions from 2011/12 onwards

In relation to the pension changes, we first need to understand the definition of a “High Income Individual”. We also need to understand what the “Special Annual Allowance” and “Protected Pension Input Amounts” are.

What is a High Income Individual?

A High Income Individual is anyone with relevant income of £150,000 or more in any tax year in which pension provision is made for them, or in either of the previous 2 tax years.

Relevant income means the individual’s total income chargeable to income tax, not just salary and bonus. This therefore includes income from employment, dividends, pensions, investments, savings interest and trusts. Importantly, we understand that this figure also includes rental income. Many people who own buy-to-let properties will have mortgages on these properties and so from an income tax point of view, mortgage interest is offset against the rental income to reduce the tax liability. However, for the purposes of establishing whether you are a High Income Individual, all of the rental income is included.

Additionally, salary sacrifices agreed after 21/04/2009 are added back in.

The individual’s pension contributions (up to £20,000 gross), gift aid donations & trading losses can be deducted. What this means is that the threshold is really £169,999 as a £20,000 gross pension contribution would mean that the individual would then not be classed as a High Income Individual, opening up the possibility of making much larger, tax-efficient pension contributions.

Special Annual Allowance & Protected Pension Input Amount

For the period 22/04/2009 to 05/04/2010, and the 2010/11 tax year, High Income Individuals will be subject to a Special Annual Allowance of the higher of £20,000 gross and their Protected Pension Input Amount. This is based on their regular provision before 22/04/2009.

One concession that has been made since our Summer newsletter is that where an individual has paid ‘infrequent money purchase contributions’ (i.e. less often than quarterly, so annual or single) the £20,000 limit can be increased to a maximum of £30,000. Where the average of such contributions paid in the three tax years 2006/07 2007/08 and 2008/09 exceeds £20,000, the Special Annual Allowance is increased to that average level, subject to an upper maximum of £30,000.

Take the following example where there are two “one off” pension contributions:

2006/07 £50,000
2007/08 £0
2008/09 £50,000

In this case, the average would be £33,333.33 which would mean that individual’s Special Annual Allowance would be £30,000.

If the figures were:

2006/07 £30,000
2007/08 £0
2008/09 £50,000

The Special Annual Allowance would be £26,666.67. This is less than £30,000 but still higher than the £20,000 allowance that was originally anticipated.

Remember that if your regular (monthly or quarterly) pension contributions are above the £30,000 p.a. level, you can continue to make these as long as the contribution is the same as it was pre – 22/04/2009. This facility is known as the Protected Pension Input Amount and applies to pension provision that was in place before 22/04/2009, that is made quarterly or more frequently, continues under the existing pension arrangement, and only increases based on contractual agreements made before 22/04/2009. There are special rules for new provision made under group schemes for 20 employees or more.

Any pension provision made in excess of a High Income Individual’s Special Annual Allowance will be subject to a Special Annual Allowance tax charge (set at 20% for tax year 2009/10).

What action should you take?

If you are classed as a High Income Individual and have regular contributions above £30,000 p.a. gross you should make sure that these continue until 05/04/2011. If you have made large, ad hoc contributions in the last three tax years you should calculate whether the combination of these gives you a Special Annual Allowance of more than £20,000. If not, you should still consider making sure that total pension contributions for 2009/10 are £20,000 to maximise higher rate tax relief. But be careful as there are many traps. For example, if you have a final salary pension, there is a formula for working out what the “notional” contribution into this scheme has been.

Income Tax & National Insurance

From April 2010, the basic personal allowance will reduce by £2 for every £1 of income over £100,000. The Personal Allowance is currently £6,475 p.a. so using this figure, anyone with income over £112,950 would lose all of their Personal Allowance.

A new 50% income tax rate will be introduced for income (other than dividends) over £150,000 p.a. A 42.5% tax rate for dividends will be introduced for income over £150,000. From April 2011, all NI rates will increase by 0.5%.

What action should you take?

We expect more and more employers will offer salary and bonus sacrifice arrangements to their employees to try to reduce both the employee and employer’s NI burden. This will be beneficial for most people.

Even if your employer doesn’t offer such arrangements, anyone with income of over £100,000 (but who is not affected by the High Income Individual limitations discussed above) should consider making a pension contribution to take their taxable income to under the £100,000 level and thus retain their Personal Allowance. This gives income tax relief at the rate of up to 60% on the pension contribution.

Post 2011 Pension Planning

Higher rate tax relief on pension contributions for those with income over £150,000 will be restricted from 06/04/2011.  Relief will be tapered away so that, for those earning over £180,000, relief will be at 20%.

Please also note that there is an expectation that contributions that a High Income Individual’s employer makes on their behalf will be taxed as a benefit in kind. This punitive regime is likely to make any form of pension contributions undesirable for many High Income Individuals.

What action should you take?

If you are a High Income Individual it may make sense to stop pension contributions post 2011 and invest elsewhere such as through ISAs, as well as taxable investments such as unit trusts that are subject to the Capital Gains Tax rules. We even expect endowments (albeit 10 year ones known as Maximum Investment Plans rather than the 25 year version) to make a comeback but more about that in future newsletters.

Remember that there will be a rolling three year “clock” and so there will be more focus on “managing” income and if it can be kept to under £150,000 for three consecutive years, there will be scope to make a big, tax-efficient pension contribution.

For now, however, the focus needs to be about making the most out of opportunities in 2009/10 and 2010/11 as much could change before April 2011.