We have written on these pages before about the tax efficiency of pensions. Pensions make particularly good planning sense for partners of professional services firms, for example, lawyers, accountants, architects and surveyors.
That being said, the rules are extremely complicated and are exacerbated by the three factors below, which will vary depending on individual circumstance and the way a partnership is structured. To summarise:
- Partnership year end – two common partnership ends are 31st March and the 30th April and they have very different implications as detailed below.
- Individual’s share of profits – special rules exist for those earning over £45,000, £100,000, £150,000 and £210,000 that make pensions more or less advantageous.
- “Pension input periods” – the most complicated concept of all, but for historic reasons individuals may be able to contribute counter-intuitively high levels of contributions with respect to the 2014/15 tax year and 2015/16 tax year through “carry forward”.
The partnership year end
A partnership that has a year end on 31st March 2018 will see the profits in the 1st April 2017 – 31st March 2018 partnership year taxed in the 2017/18 tax year and any pension contributions would need to be made by 5th April 2018 to adjust an individual’s share of profits for the purposes of taxation.
This is the simplest case to explain, but the negative implication is that this gives an extremely short window for planning, and indeed an individual may have to make a “best guess” contribution on provisional figures. Usually is more advantageous to overestimate rather than underestimate, for the reasons summarised in the next section.
Conversely, for a partnership with a year running from 1st May 2017 to 30th April 2018 the partnership financial year 2017/18 is taxed in the tax year 2018/19. This gives nearly a year to calculate what pension contributions can be made for maximum efficiency. This means a contribution can be based on final accounts so an individual with an 30th April year end has far more ability to plan than one with a March year tax end. The disadvantage, in my opinion, is it seems less logical than the first case and will take longer to receive higher rates of income tax relief (basic rate relief is normally given at source, by the pension providers).
Individual’s share of profits
An individual with a share of partnership profits of just over £45,000 has slipped from the 20% to 40% tax bracket. Where contributions are affordable, it is possible to bring earnings below the basic rate threshold which is particularly efficient if the individual expects to be a basic rate tax payer in retirement.
The effect of this is to get 40% tax relief (on the contribution over the basic rate threshold), and have the pension grow free of income and capital gains tax and be outside of the estate for inheritance tax purposes. Ordinarily the final tax rate in retirement, after the tax-free lump sum is taken off is effectively only 15% overall.
The rules are similar for those earning over £100,000 who see their personal allowance tapered away and the contribution that brings them below £100,000 will have the 60% tax relief and for those earning over £150,000 a contribution will see them have 45% tax relief, all on the element of their income that takes them over the relevant threshold.
However, for those with income from all sources over £150,000 (including rental, dividends, interest etc.) they may start to see their annual allowance reduced. The annual allowance is normally £40,000 but tapering sees it reduced by £1 of allowance for every £2 over the £150,000 threshold (subject to a minimum of £10,000).
This makes the calculation more complicated but as detailed below it is possible to “carry forward” and use allowance from previous tax years.
Where a self-employed individual makes a contribution so that the gross sum, when deducted from their income from all sources, brings them below £110,000 the tapering disappears completely which leads to the rather perverse situation that the bigger the contribution that is made, the bigger the contribution that can be made.
Pension input periods and carry forward
As explained above, most individuals will have a £40,000 allowance for the current year (the two main exceptions being those earning over £150,000 and those who have “flexibly accessed” their pensions).
There is also the ability to bring forward £40,000 from 2014/15, 2015/16 and 2016/17 before 5th April 2018. However, the current tax year and the previous tax year were potentially tapered as explained above.
Prior to the 8th July 2015 there was another complicated concept, which is beyond the scope of this piece, where an individual could have their contribution assessed against the annual allowance (testing maximum permitted contribution not the timing of tax relief) in a period that did not run concurrent with tax years.
The effect of these nonaligned pension input periods is to potentially allow an individual to make contributions in excess of the more simple 4 x £40,000 = £160,000 limit and potentially any contributions made in the pension input period ending 8th July 2015 may be excluded altogether.
It may not be practical to change a partnership year end for everyone, but for those that have an April year end it is far easier to plan for tax efficiency than those with a March year end.
That being said, those with a March year end should think about seeking advice now to see what action should be taken even where figures have to be estimated.
We specialise in planning for senior executives and partners in professional services firms and would be happy to help you in this regard.