This article by Chris Gilchrist was published in The IRS Report in June 2011.

New issues in pension planning and management

The changes introduced to UK pensions over the past year have significant implications both for people contributing to pension plans and for those withdrawing money from them. For most people, the changes are beneficial.

The major changes are the restriction of the annual allowance, the abolition of forced annuitisation, the alteration of rules on what is now termed 'capped drawdown', the introduction of flexible drawdown, and the change in the inheritance tax treatment of pension funds.

Two sets of changes coincided because the coalition government decided to pursue the previous government's aim of restricting tax relief on pension contributions for high earners, at the same time as introducing its own promised reform of the forced annuitisation that formerly applied at age 75. The latter in turn prompted a revision of the inheritance tax rules. Almost all the new rules are effective from 6th April 2011. This article covers contributions and IHT - the new drawdown system will be covered next month.

The old system gave individuals a lifetime allowance of £1.8m and the ability to contribute up to £255,000 in any one tax year into pension funds. Tax relief on such large contributions meant a big slug of higher rate taxpayers' liabilities was being diverted from the Treasury coffers. Hence the lifetime allowance is cut to £1.5m (from April 2012) and the annual allowance cut to £50,000 (from 2011).

The annual allowance comes with a three-year carry-forward. This means that for each of the previous three years you can carry forward an amount of up to £50,000 in contributions (less what you actually paid) and add this to your contributions in the current tax year. In all cases, though, the amount of contributions on which you can claim tax relief is limited to your qualifying earnings in the current year.

For very high earners, this will mean lower contributions, but for others it may enable larger contributions. For people with very erratic earnings it is likely to be advantageous.

Excess contributions above the annual allowance attract a tax liability equal to the individual's marginal tax rate, thus eliminating any benefit from making the contribution. This is straightforward in the case of defined contribution pension schemes: if you pay tax at 40% and make a contribution of £60,000, then £10,000 is excess and incurs a tax liability of £4,000, which is equal to the tax relief.

In the case of defined benefit/final salary schemes, it is more complicated. Here, it is not the actual contributions of employer or employee that are assessed against the annual allowance: it is the annual increment in the value of the pension entitlement. An example was given in response to a subscriber's enquiry onpage 8 of Issue 319. Since the actual increment in a final salary scheme is valued at a multiple of 16, anyone with an increment of over £3,125 is likely to face a tax bill. That would apply to anyone with a salary of £180,000 or more in a one-sixtieth scheme, but it could also hit someone with earnings of as little as £40,000 who got a promotion and a rise in salary to £50,000.

People facing such tax bills need to weigh the value of the rise in their pension entitlement against the tax bill. The lifetime valuation of the increment will usually be greater than the tax - the increment really is worth 16 times (often more), and you only pay tax at 40% or 50%. So younger people will probably grin and bear it. But if your accumulated pension entitlement is already large enough to fund a comfortable retirement, or your health is poor enough to make the lifetime valuation questionable, you might choose to opt out of the final salary scheme, freezing your entitlement as a percentage of earnings, and make personal contributions (possibly including contributions you persuade your employer to make) to a SIPP. Then your contributions would remain below the £50,000 limit, so you would get the benefit of tax relief and accumulate a fund you can manage as you wish.

Under the new rules, all death benefits after the age of 75 are subject to a 55% tax rate - before that they are tax-free provided no withdrawals have been made - but the payments will not be subject to inheritance tax except in special cases where people use the allocation of benefits to reduce their estates, or make large contributions knowing they are in such poor health that they are likely to die soon.

Those with larger funds will probably set up a pension bypass trust so that death benefits can skip a generation at the discretion of the trustees.

Broadly speaking, a 55% exit charge equates to the value of 40% initial tax relief, and on this basis you could consider a pension scheme an inheritance tax avoidance mechanism. Certainly, given initial tax relief at 40% or 50%, you will end up with more in a pension fund than in other investments assuming similar growth rates. But if your aim is to avoid IHT, there are better ways, especially business property (100% exempt after two years). Moreover, if you withdraw income from your pension fund under capped or flexible drawdown during your life (subject to income tax, perhaps at a rate of only 20%), and give it away more than seven years before your death, you escape IHT completely. Alternatively, you could draw the income and use it to pay the premiums on a whole of life policy under trust, again escaping IHT as the premiums will usually qualify as payments out of normal income.

Finally, as an alternative to accumulating capital in pension funds, using a qualifying regular savings plan (a unit linked endowment policy) written under a suitable trust can give greater flexibility over use of the capital plus an escape from IHT.