Pension Investors Between a Rock and a Hard Place!
Our ethos at Chesterton House is to look after the technical stuff so that you can get on with your life. Sometimes, though, it helps to gain a deeper understanding of key issues so that you can make good decisions about them, with or without the help of our Planning Team. In this occasional series of articles, one of our professionals will go into more detail about a topical subject. We hope you enjoy reading them.
In the second of two articles, Chesterton House Managing Director and Senior Financial Planner, Richard Urwin, looks into the tax traps that can affect people with higher value pension funds.
If you have a pension plan and it has a reasonable amount of money in it, it’s likely that you could be affected by the Lifetime Allowance rules. In short, if the value of your pension is more than a specified amount (£1,030,000 from April 2018) you could be liable for a tax charge when you come to draw your pension.
In my previous article I highlighted the rising number of taxpayers who are affected by LTA charges. The tax penalties applied to funds which exceed the LTA are harsh and one might seek to avoid them but, in reality for most savers, the effect is simply to take back the tax relief originally given when pension contributions were made.
Depending on your point of view, it may not seem too bad to have tax reliefs cancelled out in this way. However, for some unfortunate pension members, it’s possible that they might not only have their initial tax relief removed but could also then suffer a further LTA charge on top. The reason for this extra charge is due to the interaction between the Lifetime Allowance and the Annual Allowance. Whilst this double tax seems penal it will be a real issue for investors who find themselves affected.
The Annual Allowance is a limit on the amount of pension savings on which you can receive tax relief each year. Paying in more than the Annual Allowance to your pension in any year is not illegal, but if you do so the amount by which you exceed the Allowance is added to your taxable income. You will have to declare this via self-assessment and will be charged Income Tax on it at your highest rate. In some circumstances you can request that the tax is taken from your pension fund rather than paid directly. You will not be surprised to learn that there are complex rules around this which I won’t cover here, but our Team can help you with more details if this applies to you.
When it was introduced in 2006 the Annual Allowance was quite generous at £215,000 but, like the Lifetime Allowance, it has been successively reduced by Governments. The basic annual allowance is now £40,000 but anyone with a ‘threshold income’ of more than £110,000 a year may be subject to a tapered annual allowance.
Threshold income includes earnings from employment, self-employment, pensions, taxable interest on savings, taxable dividend income, rental income, income from a trust and any other income that is taxable in the UK. Member pension contributions are deducted from this total taxable income to arrive at “threshold income”.
If the member does have threshold income above £110,000, the rate of reduction in the annual allowance is £1 for every £2 of “adjusted income” (see below) that exceeds £150,000. The maximum that a person’s annual allowance can be reduced by is £30,000, which means the minimum tapered annual allowance for any individual is £10,000 (i.e. individuals with adjusted income above £210,000).
There is a further provision that reduces the Annual Allowance even further for savers who are drawing benefits from a drawdown plan, for whom the Allowance is restricted to a measly £4,000 pa. It is worth saying that unused allowances can be carried forward from up to three previous years and that, in all cases, tax relievable contributions are also limited to 100% of relevant UK earnings.
With money purchase pensions, sometimes known as defined contribution, it is fairly easy to work out what you and, if applicable, your employers are paying in and therefore to see whether you are breaching the Annual Allowance.
For Final Salary pensions, sometimes known as defined benefits, it is much more complex. The Pension Input Amount needs to be calculated. This is the value of benefits accrued over the tax year. The easiest way to explain this is by way of an example:
Brian has 34 years of benefits accrued in a defined benefit scheme. The scheme provides a pension of 1/60 of pensionable salary for each year of pensionable service. His pensionable salary is £150,000. In year 35 he gets a promotion and his new salary is £160,000.
Calculate the opening entitlement. This is 34/60 x £150,000 = £85,000.
Revalue this amount by the increase in the CPI. If CPI was 2.5%, the up-rated value would be £87,125. [£85,000 x 1.025].
Calculate the closing entitlement. This is 35/60 x £160,000 = £93,333.
Calculate the difference between the revalued opening entitlement and the closing entitlement. This is £6,208 [£93,333 - £87,125].
Multiply the difference between the revalued opening entitlement and the closing entitlement by 16 to get the value of the increase in the benefits accrued. The pension input amount is therefore £99,328 [£6,208 x 16].
Brian is over the annual allowance. The excess will suffer an annual allowance charge that will effectively remove all tax relief on the excess. He will need to tell HM Revenue & Customs (HMRC) that he has exceeded the annual allowance through his tax return.
If Brian earned less than £110,000 he would have the full £40,000 annual allowance plus any unused relief from the three prior years (likely to be little in his case). However, because Brian’s threshold income is greater than £110,000, his Annual Allowance is subject to tapering reduction.
To calculate the taper amount, we need to calculate Brian’s “adjusted income”. This is his total taxable income, earnings and investment income plus employer pension contributions. To calculate the value of employer pension contributions we need to take the pension input amount and deduct employee contributions. Brian pays £9,000 in pension contributions. The pension input amount is £99,328 so Brian’s adjusted income is his £160,000 earnings plus £99,328 - £9,000 = £250,328.
Brian loses £1 of annual allowance for every £2 over £150,000 adjusted earnings with a maximum reduction of £30,000. So, his annual allowance is only £10,000. Brian’s tax bill will be 45% on the amount in excess of his allowance. £99,328 - £10,000 = £89,328 @ 45%; that means a £40,198 tax bill.
In my previous article I mentioned that to calculate the LTA, Final Salary pension benefits are valued by multiplying by 20. So, let’s assume Brian retires with his 35 years’ service at normal retirement age. He has a pension of £93,333 which multiplied by 20 is £1,866,660. The LTA is £1,030,000 in 2018/19 so he has breached the LTA in a big way and a substantial tax bill is payable. This would be met by the scheme and Brian’s benefits would be reduced accordingly.
In this example Brian suffers annual allowance charges along the way to retirement and then also suffers a Lifetime Allowance charge at retirement. He is most definitely between a rock and a hard place. Pension schemes must offer the option to pay an individual's Annual Allowance charge – in exchange for a reduction in benefits - if the member has pension input in the scheme exceeding the standard Annual Allowance of £40,000 during the tax year. If pension input is less than £40,000 the member can ask the scheme to pay but the scheme is not obliged to do so.
You may not think there is much Brian can do to alleviate his situation, but knowledge of the above will affect his planning in this and other areas and may affect the timing of his retirement target date.
Note that all income including rental and investment income is included in “adjusted income”, so changes to the way investments are held may help reduce the impact.
As ever, one should not focus too tightly on technical minutiae and advice around the LTA and Annual Allowance is best delivered over many years as part of a holistic financial planning relationship. I need not remind you that our aim is to inspire people to plan and achieve their goals, get their entire financial house in perfect order, and have a great life! There’s a lot we can do to reduce the impact of these taxes, but if our only input is to be able to understand how they are applied and complete the required calculations that is probably a useful result in itself. Ignoring this complex equation is not an option!
In 2006 the Government introduced a raft of new pension laws under the title of ‘Pension Simplification.’ Ever since then, the rules have become progressively more complicated to the point where no-one without specialist knowledge could reasonably be expected to understand them. Whilst that creates work for our pension and tax teams, ultimately it removes the incentive for pension saving that will form the backbone of most people’s retirement income. It’s time we looked at the whole subject again.
Until that happens, we’re very happy to give advice to help you understand and profit from your pension planning.
Written by Richard Urwin, Dip PFS
Managing Director, Chesterton House Financial Planning Ltd