Image caption The Treasury hopes to save more than £4bn a year through the changes

The amount of tax-free income that savers can put into pensions has been sharply restricted by the government.

The annual limit will be reduced from £255,000 to £50,000 in April.

Experts have warned that some people with long service in final-salary pension schemes might face unexpected tax bills.

The Treasury hopes the changes will eventually save it more than £4bn a year - which could be used to reduce the budget deficit.

The lifetime allowance on money that can be built up in a pension fund and receive tax relief has also fallen from £1.8m to £1.5m, but from April 2012.

High earners will continue to be paid tax relief on pension savings at the highest rate at which they pay income tax.

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%.

Numbers

The government said that changing the allowance to £50,000 would affect 100,000 pension savers a year, and 80% of those had incomes of more than £100,000 a year.

The formula for calculating the increase in someone's pension if they are in a defined benefit scheme will also become more aggressive.

The increase in accrued pension will be multiplied by a factor of 16, not 10 as at present.

So someone whose pension entitlement increases by more than £3,125 in any one year may be faced with a tax bill set at their highest rate of tax.

However they will be able to offset that year's increase in their underlying pension pot against any unused tax-free allowance from the previous three years.

This will help people avoid a tax bill if they put more money into their pension scheme as a result of being given a one-off payment, such as a redundancy payment.

Mark Hoban, financial secretary to the Treasury, said the government had taken a "tough but fair" decision.

"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," he said.

Labour attacked the government's announcement, with David Hanson, Shadow Exchequer Secretary to the Treasury, saying it would "hit some families on modest incomes extremely hard".

He added: "We support the principle that pensions tax relief should play a part in getting borrowing down.

"But under our plans no-one earning under £130,000 would lose out."

'Vast improvement'

The government said that its mitigation measures would ensure that very few people earning less than £100,000 a year would actually have to pay any pension tax.

This is a vast improvement on the tortuous system for restricting tax relief proposed by the previous government Tom McPhail, Hargreaves Lansdown

Experts immediately pointed out some important wrinkles in the government's plan.

Tony Baily, at pension consultants Aon Hewitt, said: "The higher than previously proposed annual allowance and a relatively low valuation factor mean that the winners are long-serving, middle-income earners in defined benefit plans, many of whom will now not be affected by the annual allowance.

"The losers are high pension savers who get caught by the reduced and frozen lifetime allowance," he added.

Marc Hommel, pensions partner at PwC, said: "As there is no current intention to increase the tax limits, many more people could be caught in future years particularly if inflation takes off."

Ronnie Ludwig, a partner at Saffery Champness, said the new policy would discriminate against entrepreneurs.

"Because it is based on the model of regular income and regular pension contributions, it effectively discriminates against the self-employed or small business owners whose income patterns are more uneven," he said.

Tom McPhail at investment advisers Hargreaves Lansdown said the limits would still allow most people to build up a decent pension without incurring extra tax bills.

"This is a vast improvement on the tortuous system for restricting tax relief proposed by the previous government," he said.

How it will work

To illustrate how someone in a defined-benefit (normally final-salary) scheme will be affected, the Treasury gave this example.

Take a woman who has been in her employer's pension scheme for 34 years, accruing pension at a rate of 1/60th of final salary every year.

In her 35th year, her pay goes up by 20%, from £60,000 to £72,000 a year.

To work out how much her pension pot has increased, her accrued pension entitlement would be calculated as at the end of her 34th year. This would be £34,000 (34/60 times £60,000).

Then this would be revalued in line with the rise in the consumer prices index. If that had risen by 2.5%, then her accrued pension would now be £34,850.

Next, calculate her pension entitlement at the end of her 35th year. That would be £42,000 (35/60 times £72,000) as a result of that year's pay rise.

The increase in pension entitlement, at £7,150, would be multiplied by 16 to give an increase in her pension pot of £114,400.

That would suggest paying tax on £64,400 - the surplus over the £50,000 annual allowance.

However, she might have unused pension tax allowance from the three previous tax years.

Let's assume she had enjoyed 5% pay rises in each of these years, then she would still have an unused allowance to carry over of £69,400.

Adding that to her current year's allowance of £50,000 would give a total available allowance of £119,400.

This would be more than enough to cover that year's increase in her pension pot of £114,400, so in the end she would have no pension tax to pay.