The Treasury announced today that the annual allowance for tax-free pension saving will be reduced from £255,000 to £50,000 next April.
At the same time, the lifetime allowance will be reduced from £1.8 million to £1.5 million.
The government said the measures are aimed at those who make the most significant pension savings. An annual allowance of £50,000 will affect 100,000 pension savers – 80% of those will have incomes over £100,000.
High earners will continue to be paid tax relief on pension savings at the highest rate at which they pay income tax.
Someone who puts more than £50,000 into a pension in one year will also be able to offset this against their allowance from previous three years.
To protect individuals who exceed the annual allowance due to a one-off "spike" in accrual, the government will allow individuals to offset this against unused allowance from previous years.
There is concern, however, that many people with long service in final-salary pension schemes could face unexpected tax bills as a result of modest pay rises.
Andrew Penman, Director of Private Client Tax Services at PKF says: “Most individuals’ personal pension contributions are less than £50,000 a year so they are unlikely to be affected.
However, high earners, middle income earners nearing retirement and those lucky enough to be members of defined benefit schemes, could face additional tax charges or be severely restricted in their options.”
Penman points out that if an employer makes payments that take the total contributions for an individual over the £50,000 annual allowance, the employee will be hit with a 40% penalty charge.
“This could particularly hurt individuals in defined benefit schemes where the employer’s deemed contribution is calculated based on a multiple of the increase in the individual’s pension entitlement during the year,” he says.
“High earning individuals, particularly those nearing retirement, should investigate their options for making maximum contributions before 6 April 2011 to get the most into their pension pot while they can,” advises PKF’s Frank Williamson.
The changes are expected to raise £4 billion-a-year for the cash-strapped Treasury, which says it will consult on options enabling people to meet tax charges out of their pensions in November.
"We have abandoned the previous government’s complex proposals and developed a solution that will help to tackle the deficit but not hit those on low and moderate incomes,” said financial secretary to the Treasury, Mark Hoban MP, adding: “We have taken a tough but fair decision.”
John Cridland, deputy director general of the CBI, said: "The announcement is not as bad as feared. The government had considered making the annual allowance as low as £30,000. It is important now that the government appreciates the short timescale for implementation and works with companies to provide clarity."
The announcement is not completely out of the blue. Earlier this year, the coalition government began a consultation after the Labour government announced plans to gradually reduce the tax relief available on pension contributions for people earning more than £150,000 to just 20%, despite the fact that these people pay income tax of 50%.
However, the rate at which increases to the pensions accrued in defined benefit schemes will be valued is also to be put up, meaning some workers, particularly high earners who receive significant salary increases, may face tax charges.
George Bull, head of tax at Baker Tilly, says: "Once the new limit is in force, we urge the government to refrain from future tinkering in order that people can have confidence about their own pension planning."