Learning Material Sample

Retirement planning

2. HMRC Rules Part 1

In this chapter we discuss how registered pension schemes are established, the tax treatment that applies to them and the HMRC rules that apply to contributions and benefits. We briefly discussed scheme types in the previous chapter.

Scheme registration

Pension schemes subject to the new tax regime have to be registered with HMRC. Once registered they become “registered pension schemes” subject to the tax privileges described below.

Such registration procedures apply to all schemes. Unlike arrangements set up prior to 6 April 2006, there is no longer a requirement for a scheme to:

Be set up under trust

Appoint a pensioneer trustee under a small self administered scheme

Set a normal retirement age.

Tax privileges


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...ither a sole trader or a partner in a partnership

Income arising from patent rights and treated as earnings; or

General earnings from an overseas Crown employment that are subject to income tax.

The maximum that an individual can contribute to a registered pension scheme in any given tax year is the greater of £3,600 or 100% of relevant UK earnings. An individual can pay more than this but they will receive no tax relief on the excess. Note that dividends are excluded from the definitions of earnings above.

Pension simplification which came into force on 6 April 2006, known as 'A-Day', attempted to put in place one set of overall rules applying to all types of pension. The basis of the legislation behind this new regime was to be found in The Finance Act 2004 and the Pensions Act 2004, though further Pensions Acts and Finance Acts post A-Day have subsequently made changes to the initial ‘simplif...

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... a guide to legislation and regulations underpinning the new regime.

This chapter covers the rules that now apply to all registered pension schemes with those related to specific types of pension arrangement such as defined benefit schemes or stakeholder pensions covered in other chapters.

What is the name of the HMRC guide to registered pension schemes called?

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The lifetime allowance is a limit on the overall value of pension savings that qualify for tax relief. It is intended to have a similar effect as the earnings cap under the old regimes.

The lifetime allowance is set by the Treasury. The amounts set for the first five tax years of the simplified regime were as follows:

2006/07 - £1.5 million

2007/08 - £1.6 million

2008/09 - £1.65 million

2009/10 - £1.75 million

2010/11 - £1.8 million

The lifetime allowance for 2011/12 was £1.8 million (frozen at the same level as 2010/11), and from 6 April 2012, it reduced to £1.5 million. It reduced again to £1.25 million from 6 April 2014.

Fixed protection

When reducing the lifetime allowance to £1.5 million in 2012, the Government recognised that there should be a ‘protection regime’ for those who had already made pension saving decisions based on the lifetime allowance of £1.8 million. This is designed to cover those with savings above £1.5 million or who believe the value of their pension pot will rise to above this level through investment growth without any further contributions or pension savings and who did not already have primary or enhanced protection. They had to apply for ‘fixed protection’ i.e. a new personalised lifetime allowance of £1.8 million providing there is no benefit accrual in any registered pension scheme after 5 April 2012. Any excess value above £1.8 million will be subject to a lifetime allowance tax charge.

Under defined contribution schemes, benefit accrual occurs if any further relevant contributions are made after 5 April 2012. The only contributions allowed are ongoing contracted-out rebates (which are not applicable after the 2011/12 tax year) or contributions to provide life cover which was in place before 6 April 2006.

Under defined benefit schemes, it means that the benefit value (i.e. 20 times the accrued pension plus any separate PCLS) can't increase by more than the relevant percentage in any tax year after 5 April 2012. The relevant percentage is any annual rate of benefit increase specified in the scheme...

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...um of £218,750 from his personal pension and use the remaining fund of £656,250 to purchase an annuity. The crystallised value of Jimmy’s benefits was £875,000. This used up 50% of Jimmy’s lifetime allowance (i.e. £875,000/£1,750,000).

In the tax year 2010/11, when the lifetime allowance was £1.8M, Jimmy started to receive a scheme pension of £18,000 a year from a former employer’s defined benefit scheme. The crystallised value of this pension was £360,000 (i.e. 20 x £18,000). This used up a further 20% of Jimmy’s lifetime allowance (i.e. £360,000/ £1,800,000). This leaves Jimmy with 30% of his lifetime allowance available for his next BCE (i.e. 100% - 50% - 20%).

Lifetime allowance charge

The lifetime allowance charge is a tax charge that applies at any BCE where the crystallised value of the new benefits exceeds the member’s available lifetime allowance. The tax charge applies to the excess over the available allowance, known as the chargeable amount. The charge is designed to recoup the tax breaks the member has received on the excess funds over the years they have been sheltered inside the pension tax regime.

The amount of tax charged depends on the form in which the excess benefits are paid:

If the excess is paid as a lump sum, it will be taxed at 55%

If the excess is used to provide pension income, it will be taxed at 25%. But remember, the pension provided by the remaining 75% will also be subject to income tax at the member’s marginal rate of income tax.


Rashid crystallises excess benefits valued at £200,000. If he takes this chargeable amount as a lump sum, it will suffer tax of £110,000 (i.e. 55% x £200,000), leaving a lump sum payment of £90,000. If he decides to use the chargeable amount to provide pension, it will suffer tax of £50,000 (i.e. 25% x £200,000). The pension provided by the remaining £150,000 will also suffer income tax at his marginal rate of income tax.

What tax rates are used to calculate the lifetime allowance charge?

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The annual allowance is a limit on the value of pension savings that qualify for tax relief each tax year.  As with other tax allowances the annual allowance is set by the Treasury. The amounts set for the first five tax years of the simplified regime were as follows:

2006/07 - £215,000

2007/08 - £225,000

2008/09 - £235,000

2009/10 - £245,000

2010/11 - £255,000

It reduced to £50,000 from 6 April 2011 and reduced further to £40,000 with effect from 6 April 2014.

From 6 April 2011 it has also been possible to carry forward any unused annual allowance from the previous three years to offset against contributions in excess of the annual allowance in a single year.

Prior to 6 April 2011 the annual allowance did not apply to a pension arrangement in the year of death or to any arrangement in a tax year when benefits were taken in full from that arrangement. This relaxation prevented the annual allowance from applying on early or ill health retirement. It also meant that, at least in theory and subject to the then restrictions on higher/additional rate relief, all pension funding could be deferred until the year of retirement. However, from April 2011, the annual allowance applies in the year of taking benefits, except on death or on serious or severe ill health.

Pension input periods & amounts

The amount tested against an individual’s annual allowance is the pension input amount under each pension scheme for the pension input period ending in the tax year.

For schemes in existence before A-Day the first pension input period is deemed to have started on 6 April 2006 for defined benefit schemes and when the first contribution after 5 April 2006 is made for defined contribution arrangements.

For schemes commencing after A-Day it had been the case up until 5 April 2011 that a pension input period for a defined contribution arrangement started when the first contribution was paid and for other schemes it began when rights started to accrue to the member.  However, when a new pension arrangement commences on or after 6 April 2011 the pension input end date automatically defaults to the 5 April following the commencement of the arrangement unless a date earlier than the anniversary of the commencement of the arrangement has been nominated. In the case of a money purchase scheme such a nomination can be made by either the scheme administrator or the member. In defined benefit and cash balance arrangements, only the scheme administrator can make a nomination. There is no change in respect of pension input dates for arrangements commencing prior to the tax year 2...

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... individual to be an ‘active’ member at that time.

The rules require that the current year’s annual allowance must be used up before any unused annual allowance can be carried forward from a previous year and any unused annual allowance carried forward is taken from the furthest back ‘carry forward year’ first.

It should also be remembered that whilst the unused annual allowance including any carried forward determines how much can be contributed without any annual allowance charge being incurred, it is nonetheless the member’s relevant UK earnings in the current tax year that will determine how much the member can contribute and receive tax relief.

The annual allowance charge

The annual allowance charge is a tax charge that applies whenever an individual’s pension input amount for a tax year exceeds that year’s annual allowance. The tax charge is levied at the individual's marginal rate of tax on the individual regardless of who paid the contribution and applies to the excess over the annual allowance. The annual allowance charge is collected from the individual via the Self Assessment tax return.


In the tax year 2014/15 when the overall unused annual allowance available to him is £40,000, Pat makes personal pension contributions of £35,000 gross and his employer makes matching contributions. The total contributions therefore exceed the annual allowance by £30,000. To calculate the tax charge, we need to know Pat's taxable income after deduction of his personal allowance, which is £140,000. This means that £10,000 of this is in the 40% tax band and £20,000 in the 45% tax band. So Pat personally paid an annual allowance charge of £13,000 (i.e. [40% x £10,000] + [45% x £20,000]).

Individuals with annual allowance charges over £2,000 will be able to meet these from their uncrystallised pension benefit, with schemes paying the tax at the point the charge arises. This will result in the member's pension benefits being reduced. In money purchase schemes, the charge will be deducted from the fund, and in defined benefit schemes, an adjustment will be made to the accrued benefits.

All contributions paid to UK registered pension schemes, whether or not they receive tax relief, count towards the annual allowance. Only contributions paid to non-registered pension schemes, e.g. employer-financed retirement benefits schemes, do not count.

It is possible to carry forward any unused annual allowance to the current tax year from how many of the previous tax years?

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There is no longer a statutory concept of a normal retirement age. Retirement can now take place at any time after the normal minimum pension age of 55. Of course, employers may still choose to set a standard retirement age under their pension scheme.

There are 2 exceptions to the normal minimum pensions age:

Where deferred or current members of occupational or statut...

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...ension age is 55 and the lifetime allowance is £1,250,000 As he is retiring 20 complete years early, Didier’s normal lifetime allowance is reduced by 50% (i.e. 20 x 2.5%) to £612,500.

By how much will the lifetime allowance charge be reduced where a scheme member takes benefits early on the grounds of ill-health?

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Pension benefits – Compulsory Purchase Annuity

The pension is the amount of income the member’s defined contribution fund will buy at retirement after any pension commencement lump sum has been provided.

For an insured defined contribution scheme – occupational or individual – the pension is determined by current compulsory purchase annuity (CPA) costs. It is an FCA requirement that providers of individual pensions give members the opportunity to choose the insurer which is to provide their lifetime annuity. This is known as taking an open market...

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...take up to 25% of the protected rights fund as a PCLS. From 6 April 2012, contracting-out is not allowed under defined contribution schemes, so if pension schemes change their rules, there will be no differentiation between protected and non-protected rights.

Taking the maximum PCLS is almost always the best option even if the scheme member’s objective is income rather than capital because the PCLS can be applied to income-producing investments in a tax-efficient manner.

Members of what types of schemes must be offered an OMO?

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Pension at normal retirement age

As stated earlier the level of benefits that a member receives at normal retirement age depends on the following factors:

Scheme accrual rate

Pensionable service

Pensionable earnings.

The interaction of these factors will determine the level of pension payable at retirement.

Pension increases

As a pension may be paid for 25 years or more, especially if there is provision for it to continue to a surviving spouse, a scheme’s pension increases policy can therefore be crucial to establishing its quality. At current annuity rates for a man aged 65, a pension that is guaranteed to increase at 3% each year after retirement is worth around 40% more than a pension which does not increase at all.

Guaranteed minimum pension

Despite the diversity, 9 in every 10 scheme members who were contracted out of the State Earnings-Related Pension Scheme (SERPS) all have an extra protection in common. The guaranteed minimum pension (GMP) element of their total pension accrued from 6 April 1978 (when it was introduced) until 5 April 1997 is required by law to be fully protected ...

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... 15:1 basis were common, although wide differences between schemes remain. Very few schemes moved to the HMRC 20:1 valuation assumption, if only because of the extra financial burden it would impose.

Where the maximum PCLS of 25% of the value of the pension benefits is taken, the formula is:

PCLS = [20 x pre-commutation pension x C]/[20 + (3 x C)]

where C is the commutation factor used by the scheme.

Early retirement

Scheme members who cease working for the employer may start to draw retirement benefits prior to the scheme’s normal retirement age.

Frequently if a defined benefit scheme allows voluntary early retirement, it will calculate the accumulated pension benefit to the date of early retirement and then decrease that amount using a discount rate such as 4% for each year that early retirement precedes normal retirement age. In some instances this rate will be more, some less. Voluntary early retirement will usually be restricted to the minimum pension age of 55.

On what basis do pensions escalate if they are accrued between 6 April 1997 and 5 April 2005?

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All registered pension schemes can pay up to 25% of the value of the benefits (subject to the lifetime allowance) as a pension commencement lump sum (PCLS) when the payment of benefits commences.

From 6 April 2011 there are three differen...

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...e arrangements at age 77 or above (age 75 for those schemes that did not implement the override legislation brought in as a result of the 22 June 2010 Emergency Budget or where the scheme member attained age 75 before 22 June 2010). 

Once a lifetime annuity or scheme pension has commenced in payment there are 3 types of death benefit available depending on the options selected at outset:

Guarantee periods: Scheme pension and lifetime annuity payments may be guaranteed to continue for a period of up to ten years from commencement regardless of the member’s age. Such payments are taxable for the recipient(s) and cannot be commuted. In order to stimulate innovation in the annuity market, in July 2014 the Government announced that the current 10 year time limit on guarantee periods is to soon be removed, and any remaining payments in the guarantee period can be paid out as a lump sum where they are under £30,000.

Pension/annuity protection: This form of death benefit is more commonly known as ‘capital protection’ in the annuity market. Since 6 April 2011 annuity protection is available both ...

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...>Death while in receipt of scheme pension or lifetime annuity: Where an annuity is already in payment when death occurs no IHT will be payable.

Death while in income drawdown (and drawdown pension from 6 April 2011): Prior to 6 April 2011 it was also free of IHT if paid to other beneficiaries, unless the decision to start or amend income drawdown was taken within two years of the member’s death and the member was aware at that time that their state of health was poor. Though from 6 April 2011 an IHT anti-avoidance charge resulting from this ‘omission to act’ has been removed. Also with effect from 6 April 2011 IHT will not typically apply to drawdown pension funds remaining under a registered pension scheme including when the individual dies.

How has the upper age restriction for annuity protection changed from 6 April 2011?

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If an individual's total pension arrangements are relatively small in value it may be possible to convert them into a cash payment. This trivial commutation option is available when the total capital value of all of the member's retirement benefits (both crystallised and uncrystallised) does not exceed £30,000 on the nominated date (prior to 27 March 2014 the limit was £18,000). The nominated date must fall either on the first day of the commutation period, or in a 3 month window ending on that first day.

There is a window of one year within which to commut...

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...ased from two pre-27 March 2014) personal pension pots can be commuted using this rule.

The limit on each stranded occupational or personal pot was previously £2,000, but since 27 March 2014 it has been increased to £10,000.

In order to help simplify retirement rules, the Government announced in July 2014 that the age at which an individual will be able to trivially commute their benefits will soon be reduced from 60 to 55.

How are small ‘stranded’ occupational scheme pots treated under the triviality rules?

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Ill-health benefits

Subject to certain transitional reliefs, drawing benefits before normal minimum pension age (55) is only possible on grounds of ill-health.

The Finance Act 2004 defines an ‘ill-health condition’ which must be met for this to occur. The condition is that the scheme administrator has received evidence from a registered medical practitioner that the member is (and will continue to be) incapable of carrying on the member’s occupation because of physical or mental impairment, and the member has in fact ceased to carry on the member’s occupation. Although the rule implies a permanent condition, the legislation has evolved so that a scheme can suspend or reduce payment of an ill-health pension if the member regains their health.

If the member has a life expectation of less than one year, it is possible to commute their uncrystallised arrangements for a ‘serious ill-health lump sum’. The lump sum will be paid free of tax unless the member is over age 75 when a 55% tax charge will apply. The member must have some lifetime allowance remaining and each arrangement must be commuted in full. However, not all arrangeme...

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...tarted to draw retirement benefits.

Survivor's pensions are usually calculated as a percentage of the member’s pension in payment (e.g. 50%). For calculation purposes the member’s pension is usually taken as the amount he/she would have received without commuting any of it for a pension commencement lump sum. 

There is no limit on the amount of survivor’s pension that can be drawn if the member dies before their 75 th birthday. If the member dies after age 75 in receipt of a scheme pension, then the survivor’s pension is restricted to 100% of the member’s pension in the year to death, plus 5% of any pension commencement lump sum drawn by the member.

Many schemes allow an allocation option giving retiring members the chance to surrender part of their pensions so as to increase the potential survivor’s pension.

The Finance Act 2004 defines an ‘ill-health condition’ which must be met for a defined benefit occupational scheme pension to become payable in the event of early retirement due to ill health. State the main elements of this condition that must be adhered to.

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