May 06 2008
tax for mutual funds
» Escrito en Business Tips por writer3 a las 14:01
tax for mutual funds
The advent of ‘A’ Day has made the amount of contributions that can be made into a pension scheme by both employers and employees a lot more generous. In the past, contributions that could be made depended on the kind of scheme under consideration. Within a particular scheme, the level of contribution that could be made by an employer was again dissimilar to that which could be made by a member. These differences have now been sloughed, and replaced with a single set of rules. So what are the new rules that govern contributions to pension schemes by individuals as well as employers?
There is now no limit to the number of pension schemes an individual can contribute to in a given tax year. For example if you are an existing member of a final salary scheme at work, you can also contribute to a personal pension scheme or indeed a stakeholder pension scheme. There is also no limit to the total amount that can be contributed in any particular tax year. The amount that will be eligible for tax relief is albeit restricted to the greater of £3600 or 100% of the individual’s ‘relevant UK earnings’. In order to enjoy tax relief, it is also necessary that the individual qualifies as a ‘relevant UK individual’.
Let’s pause at this point and try to understand the terminologies: ‘relevant UK earnings’ and ‘relevant UK individual’. ‘Relevant UK earnings’ refers to employment income, such as salary, bonus, commission or overtime pay. It can as well denote earnings from the exercise of trade, profession or vocation, either as a sole trader or partner. ‘Relevant UK earnings’ can as well apply to earnings from patent rights that is considered as income. Income from Crown employment overseas that is subject to UK tax can also be regarded as ‘relevant UK earnings’.
It must be noted here that dividends cannot be considered as ‘relevant UK earnings. Thus income received from dividend payments when contributed to a pension scheme will not be eligible for tax relief. Some controlling directors of limited liability companies take as renumeration a small salary and a large portion of dividend. The reason for this sort of combination is that it can be a lot easier to match dividend with the cashflow situation of the company. Also dividends do not attract national insurance contributions (NICs), and there can be thus massive savings on NICs.
Obviously when it comes to putting money in a pension scheme, there will be a disadvantage, in that only a very small amount of tax relief can be enjoyed from the small proportion of salary taken. Perhaps in a year when a director expects to contribute a substantial amount towards pension, he can opt for a remuneration with a larger proportion of salary and a smaller amount of dividends; arrangements can be made to revert to previous proportions later. Another way around this sort of problem will be to get his employer to contribute a large sum in the scheme on his behalf. However, as we shall see later on in this discourse, the Local Inspector of Taxes has the right to restrict the amount of the employer’s contribution that will be eligible for relief, should there be any reason to suggest that the contribution is unduly large compared to the director’s salary; it wouldn’t matter how large the dividend is!
For a given tax year, a ‘relevant UK individual’ can be anyone who was resident in the UK at sometime during the year or has relevant UK earnings that is chargeable to income tax. It can as well refer to someone who in the past 5 years immediately before the year in question was resident sometime in the UK as well as lived in the UK in the year in which he/she joined the pension scheme. For the tax year, if an individual or his/her spouse received income from Crown employment overseas that is subject to UK tax, he/she will qualify as a ‘relevant UK individual’.
The manner in which individual contributions can be made depend on the type of scheme. With occupational pension schemes, there are two main ways in which contributions can be made: the ‘net pay method’ and the ‘relief at source method’. With the ‘net pay method’ the contribution is paid gross from the employees income before deduction of income tax. The ‘relief at source method’ involves paying a contribution that is net of basic rate tax, and the employer reclaiming the tax relief from the HMRC later. Higher rate tax payers will go a step further to reclaim a further 18% tax relief from HMRC through tax assessment or adjustment to their tax codes.
Let’s consider a case of an individual who belongs to a final salary scheme; lets assume this member wants to contribute a total of £400 to the scheme using the ‘relief at source method’. Only an amount net of basic rate tax (22%) will be deducted from the member’s income (£312); the scheme provider will reclaim the tax relief of £88 from HMRC, and the employee will further claim 18% relief of £72 from HMRC through tax assessment or adjustment to his/her tax code. So for a contribution of £400, the member would in reality have paid £400 minus £88 minus £72 which is £240. This is equivalent to a tax relief of £160 which is 40% of £400. In other words, at the end of the day, there is a tax relief at the member’s marginal rate of tax.
Before ‘A’ Day contributions to Retirement Annuity Contracts were made gross and all the tax relief claimed through tax assessment or adjustment to the member’s tax code. Current rules will permit a scheme provider to continue with this approach, if he/she so wishes.
Employers can set up any number of schemes and contribute any amount in a scheme. Employer contributions are eligible for full tax relief, as long as the Local Inspector of Taxes is convinced that the contribution is reasonable. Employer contributions are paid gross and deducted as business expense. Thus if it’s a limited liability company the deduction will be made as corporation tax. A sole trader or partnership will make the deduction as income tax.
‘Relevant excess contribution’ is defined as 110% of the contribution made by the employer in the previous chargeable year. Although the employer’s contribution may benefit from full tax relief, if the ‘relevant excess contribution’ is greater than £500,000 or if the contribution paid is greater than 210% of that paid in the previous chargeable year, the tax relief will be spread over a number of years.
In spite of the liberal nature of the new tax regime, there is a restriction regarding the recycling of the tax-free cash that is received at the commencement of retirement. This is in effect an amount for which tax relief would have been claimed already. It is possible for people to abuse the tax simplification rules by putting this tax-free cash back into the pension scheme to attract further tax relief. To check this abuse, there is only an extent to which recycling is permitted. Recycling of an amount in excess of £15,000 or 30% of the tax-free cash lump sum will be considered as unauthorised payment and will attract tax penalty.
Whilst on restrictions, one over-arching aspect of the new tax regime worthy of discussion is ‘annual allowance’. ‘Annual allowance’ can be defined as the maximum amount of ‘benefits’ that can be built in a pension scheme in a given tax year, that will not incur a tax charge’. The ‘annual allowance’ for the tax year 2007/2008 was £225,000; £235,000 for 2008/2009; £245,000 for 2009/2010; and £255,000 for 2010/2011. The allowances are to be reviewed ever 5 years and confirmed every year by the Treasury. Note that the amount in any one year cannot be less than that of a previous year.
In order to know whether the annual allowance has been reached or not, one will have to find out what the ‘total pension input’ is for the tax year. The definition of ‘total pension input’ will vary according to the type of pension scheme being considered.
For a final salary scheme, ‘total pension input’ is defined as an increase in the value of a member’s benefit rights between the previous tax year and the current. Let’s say you are a member of a company’s final salary scheme. The scheme accrues benefits of 1/60th of pensionable salary for each year of service. In 2006/2007, you had been a member for 11 years and had a pensionable salary of £67,000. By 2007/2008 your scheme service has increased to 12 years and your pensionable salary has risen to £79,000. The total pension input that will be tested against the annual allowance will be calculated as follows:
Benefit rights in 2006/2007 is given by: 1/60 by 11 by £67,000, which is 12,283.33. Benefit rights in 2007/2008 is: 1/60 by 12 by £79,000, giving £15,800. The increase in benefit rights over the year is £15,800 minus £12,283.33, which is £3,516.67. Note that it is not the increase in benefit rights that has to be compared to the annual allowance, but rather the ‘value’ of the increase. This value is obtained by multiplying the increase in rights by a factor of 10. In this case we get £3,516.67 by 10, which gives us 35,166.70. This is less than the 2007/2008 annual allowance of £225,000, and so you will not incur any tax charge; had it been greater, you would pay a tax charge of 40% on the excess.
With money purchase schemes, the ‘total pension input’ is defined as the aggregate of a member’s relievable contributions and those of the employer in a given tax year. Age rebates and incomes in excess of 100% of the member’s relevant UK earnings should be excluded from the total. Note that irrespective of the type of pension scheme, any excess of the total pension input over the annual allowance will incur a tax charge of 40%.
Great tax advantages are characteristic of the simplified tax rules. One will have to however be aware of the various restrictions and penalties that are embodied in the rules in order to enjoy the advantages to the full. A cursory glance at the rules will not be enough!
I have a BA Hons. degree in Accounting and Finance. I am currently specialising in Financial planning.
tax for mutual funds
