Pension funding limits and why 2019 is significant
Pensions offer a highly tax effective means of saving for retirement. Although pensions legislation is always subject to change, the Government wants us to save for retirement so pensions are intended to encourage us to do so. The tax relief on contributions and the freedom from income tax and capital gains tax on a pension fund are very appealing. Furthermore, since April 2015 pension freedoms have brought greater flexibility in drawing from a pension, and personal pension funds can normally be passed to beneficiaries free of inheritance tax within the pension tax wrapper, all making pensions very compelling. Hence, while the performance of investments within a pension is never guaranteed and can down as well as up, the pension “wrapper” is a highly attractive vehicle for retirement planning.
Pensions do, however, have their limits. Not knowing these limits, or not being aware of how they affect you, can result in large tax penalties. Taking professional advice when pension planning is therefore very important.
The key limits for funding UK pensions are as follows:
- Annual funding limits
- The Annual Allowance
- The Money Purchase Annual Allowance
- Relevant Earnings
- Lifetime funding limit – The Lifetime Allowance
In this article we will focus on annual funding limits, in particular the annual allowance, as it has been a hot topic recently following concerns that senior Doctors are considering reducing their hours or even retiring early to avoid annual allowance tax charges.
The Annual Allowance
On the surface, this is quite simple. Broadly speaking, it relates to the total amount of tax relievable “pension input” which can be made into an individual’s UK pension arrangements, in any given tax year.
Every UK individual under age 75 has an annual allowance of £40,000. If it isn’t used fully in any given tax year, the unused amount can be carried forward for up to 3 tax years (you must have held a UK pension in the tax year from which you carry forward).
If pension input exceeds the available annual allowance there will be an annual allowance tax charge. The charge could be up to 46% of the excess in Scotland, or 45% in the rest of the UK. In some circumstances the pension scheme can pay the charge, otherwise it is paid by the member via self assessment.
What is pension input?
For Defined Contribution (money purchase) schemes, “pension input” simply relates to the value of gross contributions paid into your pensions by you, your employer or anyone else.
For Defined Benefit schemes, however, it is a little more complex. Contributions made to the scheme are irrelevant for the purpose of pension input – the member’s pension input is based upon the inflation-adjusted annual increase in the value of benefits payable at the Normal Retirement Age. This is therefore a calculation which requires details of the accrued pension at both the beginning and the end of the pension year in question.
Tapering of the annual allowance
Although the annual allowance is £40,000, it can be reduced as a result of tapering. It is sometimes stated that the annual allowance reduces where annual income is in excess of £150,000, but it isn’t quite this simple and for some people this is very inaccurate.
The annual allowance will reduce where individuals have both “adjusted income” in excess of £150,000 and “threshold income” in excess of £110,000. Both of these income figures include all taxable income, but also consider other factors. Most significantly:
- Adjusted income includes the value of employer-funded pension contributions/accrual
- Threshold income has a deduction for personal contributions
If both these limits are exceeded, the individual’s annual allowance will be reduced by £1 for every £2 of adjusted income in excess of £150,000 until the annual allowance is reduced to £10,000.
Hence, an individual who is subject to tapering and with adjusted income of £210,000 or more will have an annual allowance of £10,000.
Why is 2019/20 significant?
The carry-forward rules allow for unused annual allowance to be carried forward for up to 3 tax years. The tapering rules commenced in the 2016/17 tax year, so 2019/20 is the first tax year where all carry-forward years are potentially subject to tapering. If there was no tapering in the previous years, up to £120,000 could be carried forward by any individual. With full tapering, it may be as low as £30,000. This means a high pension input in any given tax year is more likely to result in an annual allowance tax charge. Many individuals who would not have been subject to an annual allowance tax charge previously may now be subject to the charge by virtue of this reduction in carry-forward allowance.
The problem for Doctors
Senior Doctors have an almost perfect storm of income, working arrangements and pension arrangements to make them highly vulnerable to annual allowance charges as a result of the tapering rules. Doctors can work very long hours in any case, but they can be under pressure to work further hours to meet public needs. The NHS pension scheme is a valuable benefit to which Doctors are required to pay quite a substantial contribution – over 14% of pensionable salary in the highest band. A top pay-band Consultant can easily exceed the annual allowance before tapering is considered, so extra hours and the tapering rules can make the excess substantially greater and similarly the annual allowance charge considerably greater.
Doctors may therefore be understandably unhappy when they receive a large, unexpected annual allowance charge as a result of accrual in a pension scheme to which they have simply paid the required contribution, whilst at the same time working longer hours to meet demand. Doctors are not unique in facing this risk, but their position has highlighted the weakness of the tapering rules. There are of course consequences to society if Doctors tackle the issue by reducing hours or retiring early, so the Government is proposing greater flexibility in the NHS pension scheme. There remains pressure to review the tapering rules altogether.
Key points to remember regarding the Annual Allowance
The annual allowance is a limit which needs to be understood. Higher earners should be particularly wary of tapering.
For Defined Benefit schemes there is less clarity on the annual pension input for the current year. The rate of inflation can make a significant difference, as well as increases in salary.
Within the limits, pension funding can prove to be very beneficial. If there is any uncertainty, pension scheme members should seek financial advice.
A note on Relevant Earnings
In addition to the annual allowance, an individual’s personal contributions (which includes payments made on your behalf by anyone other than an employer) to pensions are limited by their relevant earnings, which is essentially earned income, or £3,600 if higher. This applies only to the tax year in question and there is no carry forward of unused amounts. Hence, you may have an annual allowance of £40,000 and unused allowance from previous year totalling £120,000, but if your relevant earnings are £25,000 then you are limited to tax relievable personal contributions of £25,000. This limit does not apply for employer contributions.
A note on The Money Purchase Annual Allowance (MPAA)
This is only relevant where an individual accesses pension benefits flexibly. This includes taking flexi-access drawdown income and taking an Uncrystallised Funds Pension Lump Sum, amongst other scenarios. Payment of income from a Defined Benefit Scheme does not trigger the MPAA; neither does taking tax free cash with nil income nor buying a standard (non-flexible) annuity.
If the MPAA is triggered, it will limit all future tax relievable contributions to £4,000 p.a. with no carry forward available.
A note on The Lifetime Allowance (LTA)
This is a limit on the value of UK pension benefits which can be “crystallised” without penalty. If the limit is exceeded, there is a LTA tax charge applied to the excess of either 55% (if the excess if taken as a lump sum) or 25% (if the excess is used to provide a taxable income). The current LTA is £1,055,000.
Pension benefits are tested against the LTA when they are crystallised which is typically when pension benefits are drawn, but any uncrystallised benefits will be crystallised at age 75 on death if sooner. It is not possible to avoid the LTA test, as all pension benefits will be crystallised in one way or another.
Some individuals will have a personal LTA which is higher than the standard LTA by virtue of LTA protection or enhancement. These are largely historical but some forms of protection/enhancement are still available today. They can be very valuable, but in some cases require cessation of all pension contributions otherwise the protection is lost.
Any queries?
Please contact NPWM via the details shown in the contact section of this website.