Anyone with a good size pension fund, or the ability to create one, has some key decisions to make before the end of this tax year. Whilst the attractiveness of income tax relief on pension contributions at your highest rate hasn’t changed, the rules governing pensions have been in almost constant flux for the last three years or so. Now, more than ever, advice is needed to ensure that you are maximising the tax benefits available.

In the last Budget, the government reduced the annual allowance for pension savings from £255,000 (around $422,409) per annum to only £50,000 per annum, taking effect from 6 April this year.  Whilst this may still seem generous to many, it is only the equivalent of a net of tax contribution of £25,000 per annum for someone paying income tax at the current highest rate of 50 per cent. A further important measure introduced is the facility to “carry forward” any unused annual allowance from each of the previous three tax years. This change is retrospective and therefore there is now the opportunity to use up any unused annual allowance from the  2008/09, 2009/10 and 2010/11 tax years.

For those planning on using their full annual allowance for the 2011/12 tax year, it is crucial to at the very least consider also whether to use some or all of any unused annual allowance from these previous tax years. If not used, this opportunity will be lost as we move into future tax years (for example any unused annual allowance from 2008/09 will be lost after 5 April 2012).

For those who have already accrued significant pension savings, a further change to pension rules takes effect next year that may have a serious impact on their retirement plans. The lifetime allowance for pension savings is to reduce from £1.8 million to £1.5 million from 6 April 2012. Those who already have pension savings in excess of £1.5 million need to take urgent advice to understand how they will be affected. Currently, individuals can accrue up to £1.8 million in pension savings without incurring a tax charge but the reduction in the lifetime allowance could potentially catch some people out. There is a limited opportunity for those affected to apply to HM Revenue & Customs for what is called “fixed protection” from this change to the lifetime allowance and to retain the current £1.8 million limit, however this application must be approved no later than 5th April 2011.

The importance of this fixed protection for some cannot be understated. By way of example, an individual currently with a pension fund of £1.8 million who does not have fixed protection in place by the end of this tax year will find that if they wish to retire they will be facing a lifetime allowance excess tax charge on the £300,000 pension fund in excess of the reduced lifetime allowance of £1.5 million. This tax charge is at a rate 25 per cent of the excess if used to provide a taxable pension income, or 55 per cent if the excess is taken as a lump sum – an unforeseen tax bill of up to £165,000.

The impact of the reduced lifetime allowance must also be carefully considered by those whose pension savings are currently below £1.5 million. Investment growth may lead to the lifetime allowance being exceed in the future, as may future salary increases for those lucky enough to enjoy membership of a defined benefit (final salary) pension scheme. These individuals need to decide whether applying for fixed protection will be of benefit to them at some point in the future.

It must be noted however that fixed protection is only available to those who cease all pension savings no later than 5 April 2012. This means no further contributions to defined contribution (money purchase) pension schemes or pension increases (above inflation) under defined benefit pension schemes. Any pension savings after this date will result in fixed protection being lost and being caught by the lower £1.5 million lifetime allowance.  Applying for fixed protection may not therefore be appropriate for all, particularly those who cannot negotiate an alternative remuneration package with their employer, as they may be better off continuing to accrue pension savings even if they then go on to suffer a lifetime allowance excess tax charge.

Lastly, for those who are in a position to negotiate their pension with their employer, “salary sacrifice” should be considered if not already in place. This is a simple way of optimising the tax efficiency of increasing the flow of money into a pension and reducing the cost to the individual, where they would otherwise make their own pension savings. To do this the employee gives up (sacrifices) part of their gross salary and instead their employer pays a gross pension contribution of the equivalent amount to their pension.

This has the effect of saving the employee not only income tax on the amount of salary sacrificed (potentially as high as 60 per cent for those earning between £100,000 and £114,000, as the amount sacrificed does not count as income and therefore they can potentially claim back the personal income tax allowance that would otherwise be lost) but also employee National Insurance at a further 2 per cent for those in this income bracket. Added to this, the employer saves 13.8 per cent employer’s National Insurance which can also be pass into the employee’s pension or keep as a cost saving for the business (many employers negotiate a middle ground). The combination of all of this tax relief can make pensions particularly attractive to those now paying high rates of income tax.