Senior public sector workers and high earners, particularly those in bonus or profit-sharing schemes, have something in common: both risk falling foul of an increasingly intricate web of pension rules. ‘They have to tread carefully to implement a sound retirement plan, as government tinkering with the rules has made this area highly complex,’ says Tom Munro, founder of Tom Munro Financial Solutions.
There are no limits on pension contributions, but tax relief can only be claimed on investments of £40,000 a year or worth up to 100 per cent of gross annual earnings, whichever is higher.
The annual allowance has been cut back sharply over the years. At one time it stood at £255,000, but it was reduced to £50,000 from the 2011/12 tax year and to £40,000 from 2014/15. From 2016/17 the allowance has also been tapered for those with incomes of more than £150,000, hitting a floor of £10,000 for those earning more than £210,000.
Marlene Outrim, managing director at Cardiff-based UNIQ Family Wealth, says: ‘The allowance has changed considerably over the years, so if you haven’t been keeping up to date or seeking advice, it’s easy to keep saving without realising you could face a hefty tax charge.’
So who is at risk, and what steps can they take if they are in danger of breaching the threshold?
SENIOR PUBLIC SECTOR WORKERS
High earners contributing to personal pensions or occupational defined contribution schemes can easily establish whether they are likely to exceed the annual allowance by simply adding up the value of their contributions.
Kate Davenport, senior technical assistant at Robertson Baxter, says: ‘For most people, it’s easy to see how much has been paid into their pension arrangements in any given tax year: it’s the total of employer contributions plus personal contributions, grossed up, so an £80 contribution is £100 paid into the scheme.’
The calculation is more complex for those in active final salary pension schemes, typically the preserve of the public sector nowadays. Employees with long service, especially those who are promoted and receive decent pay rises, are most at risk, according to Scott Gallacher, a director at Rowley Turton. ‘I did some work for a new headmaster who had been promoted rapidly. His salary and therefore his final salary pension had increased significantly,’ he says.
With final salary pensions, also known as defined benefit schemes, contributions are based on the increase in the value of a member’s accrued pension benefits over the tax year, rather than the contributions they made. The starting point for members worried about breaching the limit is to ascertain their benefits accrual rate. ‘In our experience, many people don’t know this. Ask your scheme administrator,’ says Guy Kelland, managing director at financial planning firm Kellands.
Gallacher gives the example of John, who is in a 1/60th final salary scheme, which means that for each year of service, he earns a pension of 1/60th of his final salary. John has 30 years’ service and earns £30,000 a year, so he has a final salary pension of £15,000 a year (30/60ths of £30,000). When John is promoted, his salary is increased to £40,000 a year. With the pay rise and extra year’s service, his final salary pension rises to £20,666 a year (31 /60ths of £40,000).
HMRC multiplies the increase in accrued pension by 16 for the purposes of testing against the annual allowance, so John’s increase in benefits is £90,656 (£20,666 - £15,000 = £5,666 x 16) – far greater than the £40,000 limit.
HIGH EARNERS CAUGHT BY TAPER
Those with ‘adjusted income’ (which includes employer pension contributions and benefits in kind) of more than £150,000 have their annual allowance reduced by £1 for every £2 of income over that limit. Those earning more than £210,000 have their allowance reduced to £10,000.
Final salary scheme members will exceed this if their annual pension entitlement increases by more than £625 (£625 x 16 = £10,000), compared with £2,500 for those with a full allowance (£2,500 x 16 = £40,000), figures from LIFT-Financial show.
Nicola Watts, a director at Jane Smith Financial Planning, gives the example of Anne, who earns £225,000 and is a member of a 1/60th final salary scheme with 25 years’ service, which gives her a pension of £93,750. During the tax year, her salary increases to £230,000 and, given an extra year’s service, her pension entitlement rises to £99,666.67.
HMRC equates the £5,916.67 uplift to a £94,667 increase in benefits (£5,916.67 x 16). As she has an annual allowance of just £10,000, £84,667 is added to her taxable income and taxed at her highest marginal rate of 45 per cent – a potential tax charge of £38,100.
HIGH EARNERS WITH IRREGULAR INCOME
As mentioned above, adjusted income includes all taxable income – salary, dividends and rental property income – as well as employer pension contributions and benefits in kind, such as medical insurance premiums paid by an employer.
It is important to look at total income, not just earnings or trading income, as spikes in dividends and one-off payments such as bonuses or profit shares can push you into taper territory.
Gary Heynes, national head of private client at accountancy firm RSM, says: ‘There’s also a problem if taxable income is not known until after the year end, especially for the self-employed, where tax adjustments may be needed, or for partners who may not know their profit share.’
FOUR WAYS TO BEAT THE RULES
1. Carry forward
Carrying forward unused annual allowances from the previous three tax years ‘may be sufficient to deal with one-off blips’, says Jonathan Halsall, a chartered financial planner at LIFTFinancial. A total of £160,000 can be invested in 2017/18, provided no contributions have been made since the start of the 2014/15 tax year.
2. Get your scheme to pay
In certain circumstances, a pension scheme may pay a tax bill in return for the member giving up some pension benefits. ‘People can use ‘scheme pays’ rules to have the pension scheme pay the tax charge and reduce their pension benefits accordingly,’ says Gallacher.
The tapered reduction doesn’t apply to anyone with threshold income (excluding pension contributions) of £110,000 or less. However, anyone with income around this level should review their affairs, as spikes in income and employer contributions could limit their tax relief allowance. Heynes recommends that those in defined contribution schemes pay less than the allowance and carry forward any unused relief.
4. Use alternative savings
While pension contributions ‘remain the go-to option for most retirement savers’, high earners should consider alternatives such as Isas, offshore bonds or collective investment portfolios, says Nick McBreen, an adviser at Worldwide Financial Planning.
The Isa allowance will rise to £20,000 for 2017/18, which means couples can save £40,000 a year and ‘accumulate a substantial tax-free income stream in retirement’, says Munro. From this year, there is also the lifetime Isa for those aged 18-40. It allows savings of up to £4,000. Contributions made before age 50 trigger a 25 per cent bonus from the government, provided the funds are untouched until age 60.
BE CAREFUL WHEN ACCESSING YOUR PENSION WHILE WORKING
Those who access pension benefits while still working risk triggering the money purchase annual allowance (MPAA), which has been reduced to £4,000 for the 2017/18 tax year, from £10,000 last year.
‘The MPAA is designed to limit pension recycling, whereby pension withdrawals are paid back into a pension, receive tax relief and build up a 25 per cent tax-free cash entitlement for a second time,’ says Michael Brooke, a pensions specialist at Clarion Wealth Planning.
Pension savings are accessible from age 55, with 25 per cent available as tax-free cash. Those who then go into ‘flexible access drawdown’ and draw a taxable income from their pensions will effectively restrict their annual pension contributions.
Paul Richardson, managing director at Concept Financial Planning, believes the new £4,000 allowance is ample for many people: ‘A monthly gross contribution of £333 is still possible. Someone in the decumulation stage of life on a 5 per cent contribution would need to be earning more than £80,000 [to be caught].’
However, those who access their pension fund early but still want to build their fund face a problem. ‘The new limit will have a big impact on those who want to use their pension fund to supplement employment income or pay off debts but also want to continue building pension savings,’ says Lee Sweeting, a pensions specialist at tax group Smith & Williamson.
An employed client of Nicola Watts at Jane Smith Financial, for example, needed to pay o an interest-only mortgage, and pension savings were the only source of available cash. However, they needed to withdraw more than just the 25 per cent tax-free lump sum, which triggered the MPAA, reducing their annual allowance to £10,000.