Pensions

Personal pension rules are complicated, but set to become simpler, says Pam Atherton.

The self employed, of whom there are 4.3m in the UK according to the Inland Revenue, are on their own when it comes to pensions.

Not only were they not entitled to the State Earnings Related Pension Scheme (Serps), but nor are they eligible for its replacement the State Second Pension (S2P).

The only types of pension plan that the self employed can contribute to are personal pensions, including Self Invested Personal Pensions (Sipps) and stakeholder pensions. Some self employed people still have access to Retirement Annuity Plans (RAPs) which were sold to the self employed before 1988.

Contribution levels

Contributions are age related and based on a percentage of your 'net relevant earnings' which are your gross earnings less allowable expenses, up to an earnings limit of £102,000 in the current tax year.

Personal pension contribution limits

Age          % of net relevant earnings

Under 36   17.5
36-45        20.0
46-50        25.0
51-55        30.0
56-60        35.0
61-74        40.0

Earnings limit £102,000

Tax relief

All contributions attract tax relief at your highest rate of tax and are automatically made net of standard rate tax at 22%. This means that a basic rate taxpayer making a gross contribution of £1,000 only has to fork out £780.

Higher rate taxpayers have to claim back the extra 18% tax relief via their self assessment tax return. So on a £1,000 gross contribution , a higher rate taxpayer could claim a further £180 back from the tax man.

Basis year

People investing in personal pensions have until 5 April 2005 to maximise this tax year's contributions using the so called "basis year" rules.

This rule allows you to contribute to a personal pension on the basis of your best year's earnings in any of the last five tax years - even if you are currently earning nothing and are a non taxpayer.

Contributions of up to £3,600 can be made regardless of earnings and the money can come from any source, such as a redundancy payment, an inheritance or investment income.

But contributions over that level will be dependent on earnings and will be subject to the personal pension contribution limits outlined above.

The basis year rules represent a major tax planning opportunity for anyone with a personal pension who experiences a drop in their earnings because of retirement, maternity leave, redundancy or who has variable earnings.

For instance, a man aged 64 and who expects to earn £15,000 in the current tax year but who had an income of £50,000 in, say, tax year 2000-2001 could nominate that year as his 'basis year' and make maximum pension contributions in that year, and the next five years up to the tax year 2005-06, based on his £50,000 earnings in 2000-01 (see table).

As he is 64, he can contribute up to 40% of £50,000 or £20,000 gross (£15,600 net of standard tax, £12,000 net of higher rate tax) until 2005-06 (to the extent that he has paid higher rate tax).

Anyone with a RAP can still do what is called 'carry back/carry forward'. These policies, often referred to as Section 226 policies, allow you to mop up unused tax relief going back up to six years and to carry forward unused relief one year.

Simplification

But all this will change in April 2006 when all pensions will be simplified across the board, so that there will be one annual contribution allowance based on 100% of earnings up to £215,000 in 2006-07 (regardless of whether you are employed or self employed) or £3,600 pa if you have no earnings.

Claire Court, a pensions consultant at IFA firm, Origen, comments: "Pensions simplification in April 2006 will bring many benefits to the self-employed, notably more flexibility over the timing and level of pension contributions."