Since ‘A-day’ in 2006, the pension’s simplification rules have allowed Contractors to dramatically reduce their tax bills by contributing a large proportion of their income into a pension scheme. In fact, the only barrier to cap your contributions was the lifetime allowance of £1.75 million and the annual allowance of £245,000 (for 2009/10) and aside from this, it was left to the individual to decide how much to contribute from your annual income.

Using a pension as a route to reduce tax was particularly lucrative for higher earners. The result was that many exploited the freedoms to the full and the 1.5% of top earners received 25% of all pension tax relief last year. However the benefits were not only felt by the UKs millionaire community. Using pensions as a tax planning tool meant that many Contractor clients were pocketing more of their hard earned income than ever before, with some choosing to take a minimal wage or dividend in order to save tax on a all of the rest of their annualised contract income.

The budget rains on the pensions parade

The Budget speech announced that income tax was rising to 50% and this looked set to make pension investment even more of a tax break. The mood was soon dampened by the announcement that the Chancellor would be clamping down on the extent to which pensions could be used for tax relief.

From April 2011, tax relief for Contractors that earn over £180,000 will be capped at the basic rate of 20% and those earning between £150,000 and £180,000 will be judged on a sliding scale of between 40 and 20%.

Whilst the initial reaction from investors and industry professionals alike was to adapt a ‘buy now while stocks last’ mentality, it soon became apparent that the Chancellor was one step ahead of the game. Anti-forestalling rules have been put in place to prevent high earners from maximising contributions over the next two years in order to make use of the tax breaks before they disappear.

‘A-day’ to may day – pensions simplification it is not!

The new restrictions that have been put in place mean that Contractors who have already earned £150,000 or more this year or over the past 2 years, will be restricted to 20% tax relief on pension contributions above a ’special annual allowance’ of only £20,000. Unfortunately, this extends to both employer and employee contributions.

This impacts on your ability to contribute through salary sacrifice arrangements if you operate under an Umbrella company and stops you using unlimited company contributions if you contract via a limited company.

Whilst it is still unclear how the new pensions restrictions will work in practice, any Contractor earning up to £149,999 per year is entitled to invest almost all of it in a pension without incurring income tax, corporation tax, National Insurance deductions or being liable as for benefit in kind. However, if you earn just £1 more than that you are only able to invest up to the special annual allowance of £20,000. It is worth bearing in mind that the £150,000 earnings they are referring to, does not only include salary but also income such as rentals from buy-to-let properties, dividend income and bank interest.

If you invest over this £20,000 limit then you will be subject to a repayment of the balance between the basic and higher rate tax relief that you will gain on this excess investment. This tax relief repayment will probably be via your self-assessment return.

A silver lining for savvy investors

One saving grace is that pre-existing investors who have exceeded the £20,000 limit will still benefit from their current tax relief arrangements as long as they were contributing regularly on a monthly or quarterly basis before April 22nd 2009. These pre-existing regular contributions will be known as ‘protected input amounts’ and so someone that already contributed £3000 per month will be able to continue to contribute that amount and benefit from 40% tax relief.

For those savvy pension investors, keeping up regular contributions will be crucial in order to continue receiving the tax relief benefits that you currently enjoy. Any investment that exceeds the special annual allowance of £20,000 and your individual ‘protected input amount’ will be charged at a rate of 20% this year and 30% in 2010.

Unfortunately for those contractors that employ a more ad hoc approach to pension investment, this pre-existing contribution bonus does not apply. Investors that prefer to invest via a lump sum at the end of the tax year will therefore fall foul of the new rules.

Missed the boat? There may be another route

If you are in the fortunate position of narrowly missing the £150,000 earnings cap, then now is the perfect time to maximise contributions in case of any further increase in earnings or new rules coming into play. The most effective way of contributing is likely to be through regular investments on a monthly or quarterly basis as we have already seen various concessions being made for regular contributors and this could lead to further savings in the future.

If your earnings exceed the £150,000 limit then it is arguably more important than ever to invest up to the £20,000 special allowance in order to exploit one of the few remaining tax breaks for Contractors. If you invest the full £20,000 then the tax man is effectively paying £8,000 which is a worthwhile return on your investment and with savings rates at an all time low, it might represent the best place to invest in the current climate.

Also if you earned over £150k last tax year but wont do so this year there is a way to reduce your income back down under the threshold using a Gift Aid donation for 2008/9.

With concerns growing over the future of state pensions due to the shrinking workforce and increasing longevity, the emphasis is on personal investment to provide for your retirement. It is therefore highly unlikely that the Government will abolish higher rate tax relief altogether and if anything, the higher taxes announced in the budget provides an even greater incentive for Contractors to make regular contributions towards their future.

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