Pension and Taxation - Case Study Example

Taxation Table of Contents Introduction: Definition of pension 3 Pension and associated taxes 3 Importance of pension from taxation and planning perspective 5 Types of pension 7 Types of pension schemes 8 Tax relief on contributions made towards pension & Benefits of pension in aiding investment 9 Changes in pension from view-point of taxes 11 Conclusion 12 Reference 13 Introduction: Definition of pension Pension is an arrangement whereby, the people are provided with a source of income in the post-employment period. The retiree or the pensioner is entitled to regular instalments from the amount accumulated over his working life. The amount that is contributed towards pension depends on contractual and legal terms. The employee as well as employer has to make regular contributions to a fund which can be later used as post-employment income. Pension and associated taxes The lump sum payment on pension is absolutely tax-free but the monthly payments are treated like income and are subject to taxes (Strathclyde Pension Fund, n.d.). The new tax regime consists of a “single set of rules” for taxes relating to pension savings. The important features of this new system includes the following- No limit has been set on the pension amount saved by an individual under the registered pension scheme. There are two main controls- annual allowance and lifetime allowance. A “single lifetime allowance” or LTA against which the pension savings of an individual will be matched when they draw their benefits. As on 6 April 2008 this amount was £1.5 million and it will rise to £1.8 million by the financial year 2010/11. Annual Allowance relates to any increase in amount of pension savings in a fiscal year. In the year 2006 this was £215000 and will rise to £255000 for the fiscal year 2010/11. All these will benefit the individuals, employers as well as the pension industry. The individuals will be encouraged to save more for their retirement along with greater flexibility and choice in terms of investing in a variety of pension schemes. Pension industry will enjoy the benefit of lower administrative costs and enhanced customer services and this will also benefit the employers (HM Revenue & Customs, 2005). After reaching the “State Pension age” an individual does not have to make National Insurance Contributions (NICs) but this does not stop the payment of income taxes. If the amount of taxable income taking State Pension into account exceeds the tax-exempt personal allowance then the individual has to pay taxes. Other than State Pension if an individual gets other pensions like company or personal pension or retirement annuity and pays taxes on the same then he has to pay taxes on State Pension as well (Directgov-b, n.d.). The amount of taxable income comprises of various pension schemes, income derived from self-employment as well as employment, dividend income, overseas income, property income, interest from building societies and banks etc and non-taxable income includes Pension Credit, interest earned from National Savings Certificates, lump sum payments on pension, bonuses and interest on SAYE or “Save as You Earn “ scheme, winnings from National lottery & Premium bonds, interest earned on ISA or “Individual savings Account” or accounts that are exempted from taxes etc (Directgov-c, n.d.). Importance of pension from taxation and planning perspective Due to pension crisis the government wants to encourage people to make retirement plans well in advance. The benefits of contributing towards a pension scheme during the working tenure includes the following- The contributions made entitle an individual to get tax relief at the highest income tax rate. The contributions made by the employer towards personal pension or company pension schemes can lower the amount of taxable business profits as such contributions are treated as ‘business profits’ at the time of computation of taxes. The lump sum received from pension at the time of retirement is also tax-free. With effect from 6 April, 2011, the government has announced restrictions on tax relief relating to pension contributions which includes the amount of employer’s contribution, for people having taxable income which is higher than or equal to £150000. The taxes on pension were overhauled by the government in the year 2006. The complex rules gave way to a set of unified rules making the process of retirement planning flexible and simple. Like an individual can now save in more than one pension related scheme. For the fiscal year 2010-11 a person can attract tax relief on the amount of contributions up to hundred percent of the earnings in a year subject to an annual allowance of £255000 for 2010-11. On any amount in excess of this annual allowance an individual has to pay “an allowance charge” of 40 percent on such contributions or the amounts that are in excess of the annual allowance provided the tax relief on these contributions have been given (Laing, 2010, p.122). Importance of pension planning- An individual cannot work for his entire life; therefore it is important that he sets aside some amount of money for the post-retirement age so that it can be spend in comfort. This has increased the importance of pension. By way of pension an individual can receive regular monthly annuities even after employment this taking care of his needs post-employment. Moreover the pension contributions entitle an individual to certain tax-free allowances thus lowering his overall tax burden. This is the reason that a number of pension schemes have come up based on the need of every person. Types of pension Pension is mainly of three types-State Pensions, Personal Pensions and Company Pensions. State Pension is “a regular payment” that can be claimed by the people once they reach the State Pension age. The amount received by every individual varies. State Pension- This kind of pension gives a regular source of income for an employee’s remaining life. In 2010-11 an individual can receive a maximum of £97.65 per week as basic State Pension. A number of people can get an amount higher than this as they also get additional State Pension. For State Pension the required age is 65 for men and with effect from 2010 this age has changed from 60 to 65 for women by 20120 (Directgov-a, n.d.). Company Pension- This type of pension is established by the employers to contribute towards pensions for the employees. These are also referred as workplace pension or occupational pension. The set of rules varies across companies but the amount can be contributed from the salary of both the employee’s salary & by the employer. The tax relief is given on the amount contributed up to a maximum of annual allowance. Personal pensions- These types of pensions are provided by the banks, life insurance companies and building societies who invest the generated savings on the behalf of the individuals. An individual can invest as much he wishes in this type of pension and the amount of tax relief is available up to a maximum of annual allowance (Directgov-d, n.d.). Types of pension schemes Defined benefit Scheme- This type of scheme is given by the employer as a constituent of an employee’s occupational pension and is referred as “final salary pensions”. The benefit to be paid to the members at the time of retirement is estimated by the actuary. This calls for various actuarial assumptions relating to investment return, inflation, growth rate of earnings, increases in salary etc (Moneyengines.co.uk Ltd-a, n.d.). “Final salary pensions” come under the purview of defined benefit schemes. A defined benefit scheme is a form of pension where the ultimate benefits of the pension holder are stated clearly under the scheme rules. An advantage of this type of scheme is that the onus of accommodating any deficit lies with the employer, making it a very attractive option (The Tax Guide, n.d.). Money Purchase Scheme- These types of schemes enable the employer and employee to make contributions towards retirement funds thus supplementing the amount received from the “basic State Pension”. After retirement the accumulated pension is used for buying an annuity. An important benefit of such schemes is their relative straightforwardness. The employer facilitates in building up a “retirement fund” offering a host of investments for achieving the retirement goal. But this type of scheme also has certain limitations. The amounts are invested in such schemes with the hope of significant growth at the time of retirement. But the growth in investment is not guaranteed to the desired level. These types of schemes provide a variety of funds of varying risk levels. One can choose to invest in risky funds in the initial years and increase the weight of safer assets as an individual is close to the retirement age. The money invested in such schemes is managed by the professional manager or an insurance company (Money Sheets, n.d.). Public Service Scheme- The armed forces, civil services, NHS, fire services, NHS, local authorities and police have access to this type of scheme for benefits relating to retirement. Here the rules of the scheme are defined as per statutes. For a “principal civil service” scheme there are no direct costs attributable to the members of the scheme. Contrary to this the members of the “NHS Pension scheme” have to make contributions approximating 6 percent of the pension able earnings. The accrual rate for this type of scheme is one-eightieth of the amount of final salary for every year of service subject to a maximum “pension income” of forty-eightieth for 40 years of an employee’s service. As the statutory schemes are notionally funded or unfunded there is no requirement for compliance with the minimum requirements of funding. The benefits derived under such schemes are guaranteed by the statutes unlike the pension schemes of the employers of the private sector (Moneyengines.co.uk Ltd-b, n.d.). Tax relief on contributions made towards pension & Benefits of pension in aiding investment The government offers impetus to save for retirement by allowing tax relief on amounts contributed towards pensions. This helps in reducing the tax bill and increasing the pension fund. For the company or public services pension schemes the employer deducts the contributions form the salary before making deductions for taxes so the tax is paid only on the amount that is left. So irrespective of whether the tax rate is additional or basic or higher an employee gets the benefits right away. Under Personal Pension an individual pays an income tax on his earnings prior to making any pension contributions however the taxes are claimed back by the pension provider from the government at the rate of 20 percent. An individual can save as much as he wishes into any type and number of registered pension schemes and obtain tax relief on such contributions up to a maximum of 100 percent of the earnings in a year given that the contributions are made before the age of 75. However the amount saved every year is subject to an annual allowance. For the fiscal 2010-11 this allowance is £2550000 and for 2009-10 this amount was £245000. For any contributions made in excess of this annual allowance the rate of tax is 40 percent (Directgov-e, n.d.). By way of pension an individual can be assured of getting regular monthly sum of money that can take care of old age expenses. Unlike mutual funds investment in pension is relatively secure as this is done with the motive of accumulation of money rather than taking risk to get some windfall gains. In the initial stages of an individual’s working life one can assign a higher proportion of salary towards pension contributions as the expenses are comparatively less during this period. This helps in building a corpus that can be channelised into various avenues that require funding. As the amount in pension is invested for a long term the chances of early withdrawal are less enabling the use of this money for long term projects, with long gestation periods. Once these projects are through it helps in raising the overall earnings of the economy. Therefore pension is an important source of investment as it forms an important part of long term projects like infrastructure development. Moreover the tax breaks given to an individual for making pension contributions help in lowering their tax outflow. The performance of mutual funds is better than the pension funds when seen from the short term perspective but the opposite is true when measured from the long term point of view. This means that pension fund is an attractive investment option over the long term as the estimated return offered by it is higher than that offered by the mutual funds during the same period (Srinivas & Yermo, 1999. p.29). Changes in pension from view-point of taxes The rise in the ageing population of Britain means that the number of people paying taxes is few in number and number of people receiving State pensions is more. The percentage of people making savings through pensions is also not very significant. For this reason the government has introduced some changes to make the pension contributions attractive. Like if an individual is not a part of any pension scheme he will get enrolled in the “personal account pension scheme” referred to as NEST from the year 2012. This will contain the option of opting out. Changes have also been made to the “State Second Pension” in terms of calculation. The government plans to increase the State pension age for both men and women. Other than this the other changes to the State Pension have also been made which will apply for men with the date of birth on April 6, 1945 and women with date of birth on April 6 1950 (Moneysorter Ltd. n.d.). For tax year 2010-11 the high income earning individuals will be allowed a special annual allowance which will be higher of £20000 and “Protected Pension Input Amount”. Higher tax relief on pension contributions of those with an income of more than £150000 will be restricted. This has been criticised by the people as unfair. On the basis of tax rate of 50 percent and withdrawal of tax relief the government hopes to raise approximately £3.9 billion by imposing a tax of 50 percent on earnings above £150000. The main aim behind this is to restrict the pension tax relief available to the high earners. Some of the high earners are expected to be taxed on the amount of pension contributions made by the Employers (BBC News, 2010). Conclusion In a bid to make ‘pension’ an important savings instrument the government has raised the Annual Allowance to £255000 from the fiscal year 2010/11. The employers’ contribution towards personal or company pension schemes will lower the amount of taxable business profits as these contributions will be allowed as a tax deductible expense. This is good from the viewpoint of the employees as well as it lowers their burden of tax bill. All this is likely to encourage the employees to make large contributions towards pension. Moreover the lower administration costs will bring in a number of benefits for the pension industry thereby, resulting in a number of flexible and customer friendly savings schemes. This is important as it will boost the savings of the economy which is currently reeling under the pressure of ageing taxes. With a higher amount of pension contributions qualifying for tax exemption the working population will be enticed to park their funds in various company and pension schemes. Reference BBC News. 2010. Pensions tax changes for high earners criticised. Available at: http://news.bbc.co.uk/2/hi/business/8543505.stm [Accessed on October 8, 2010]. Directgov-a. No Date. State Pensions - an introduction. Pensions and retirement Planning. Available at: http://www.direct.gov.uk/en/Pensionsandretirementplanning/StatePension/DG_183754 [Accessed on October 8, 2010]. Directgov-b. No date. Tax on your State Pension. Money, tax and benefits. Available at: http://www.direct.gov.uk/en/MoneyTaxAndBenefits/Taxes/TaxOnBenefitsPensionsAndMaintenance/DG_172143 [Accessed on October 8, 2010]. Directgov-c. No date. Do you have to pay tax in retirement?. Pensions and retirement planning. Available at: http://www.direct.gov.uk/en/Pensionsandretirementplanning/TaxandNationalInsuranceinretirement/GettingyourtaxandNationalInsuranceright/DG_10014681 [Accessed on October 8, 2010]. Directgov-d. No date. Types of pensions. Pensions and retirement planning. Available at: http://www.direct.gov.uk/en/Pensionsandretirementplanning/BeginnersGuideToPensions/DG_10027104 [Accessed on October 8, 2010]. Directgov-e. No Date. Tax relief on pension contributions. Pensions and retirement planning. Available at: http://www.direct.gov.uk/en/Pensionsandretirementplanning/BeginnersGuideToPensions/DG_10026927 [Accessed on October 8, 2010]. HM Revenue & Customs. 2005. About Pensions Tax Simplification. Pensions Tax Simplification Newsletter No 1 June 2005. Available at: http://www.hmrc.gov.uk/pensionschemes/newsletter1.htm#5 [Accessed on October 8, 2010]. Laing, S. 2010. Tax 2010/2011 for Dummies. John Wiley & Sons Ltd. Moneyengines.co.uk Ltd-a. No Date. Defined benefit scheme. Available at: http://www.sharingpensions.co.uk/marbreak6.htm [Accessed on October 8, 2010]. Moneyengines.co.uk Ltd-b. No date. Public service scheme. Pensions. Available at: http://www.sharingpensions.co.uk/employpen2.htm#text3 [Accessed on October 8, 2010]. Money Sheets. No date. All About Money Purchase Schemes. Available at: http://www.moneysheets.co.uk/about-money-purchase-schemes.html [Accessed on October 8, 2010]. Moneysorter Ltd. No Date. UK Pension Reform. Available at: http://www.pensionsorter.co.uk/pensions_reform3.html [Accessed on October 8, 2010]. Srinivas, S.P. Yermo, J. 1999. Do investment regulations compromise pension fund performance?: evidence from Latin America. World Bank Publications. Strathclyde Pension Fund. No Date. Tax and your pension. Available at: http://www.spfo.org.uk/MembersServices/PensionerMember/TaxAndYourPension/ [Accessed on October 8, 2010]. The Tax Guide. No date. Defined Benefit Schemes. Available at: http://www.thetaxguide.co.uk/DefinedBenefitSchemes.html [Accessed on October 8, 2010]. Bibliography Davidson, A. 2005. How to understand the financial pages: a guide to money & the jargon. Kogan Page Publishers. Grand, L.J. Agulnik, P. 1998. Tax Relief and Partnership Pensions. Available at: http://siteresources.worldbank.org/INTECA/Resources/pension_reform_in_see.pdf World Bank. 2009. Pension Reform in Southeastern Europe. Available at: http://siteresources.worldbank.org/INTECA/Resources/pension_reform_in_see.pdf Read More