Background:
Having dealt with pensions tax challenges over many years across a range of circumstances, some of the rhetoric on the freezing of the Lifetime Allowance (LTA) in last week’s budget makes me nervous.
Pensions taxable allowances are complicated beasts that cause much confusion and many questions. In this brief blog we have set out some of the common questions and answers. We also make the point that it rarely makes sense to opt out of valuable pension accrual simply to avoid a tax charge on part of that accrual.
However, this is merely a snapshot into something which is much more complicated and so you must look at your own position very carefully and seek advice or guidance where required.
Q: What is the Annual Allowance (AA)?
A: The AA is the limit on your pension savings in a tax year. Anything up to the allowance retains the full tax relief and anything over the allowance may become subject to tax.
The AA is currently set at £40,000 but has changed over the years. It can also be lower. Someone who is subject to a lower AA is classed as a high earner, for these purposes.
Between 2016/17 and 2019/20 tax years, a high earner was defined as someone whose total taxable income was more than £110,000. From 2020/21 this has increased to £200,000.
So, your allowance may be different depending on which tax year you are assessing.
Q: Is the value of the pension savings just the contributions that have been paid?
A: It depends on the type of pension scheme(s) you are a member of.
If you are a member of a defined contribution scheme (AVC, personal pension, stakeholder, most private sector workplace pensions), then the pension growth is the contributions which you and your employer have contributed.
If, however you are member of a defined benefit scheme (such as most of the public sector schemes), then this is more complex. We have to calculate something called the Pensions Input Amount (PIA). This is an assessment of how much your annual pension has grown over the tax year, adjusted for inflation and then multiplied by a HMRC factor.
Your pension scheme can provide you with a Pension Savings Statement, which will tell you the estimated PIA for the tax year. You can then use this as an initial basis to review your position.
Q: If I have not received a Pension Savings Statement from the pension scheme does this mean there is no issue?
A: No. The pension schemes will usually issue a pension savings statement if they think an individual has breached the standard AA of £40,000. But, if you have a lower allowance, you may not have received a statement, and you may need one.
As a rule of thumb, if you have taxable income over around £110,000 or have had an increase in your pensionable pay which is above inflation – due to an increment, additional award, ceasing a salary sacrifice scheme, promotion and so on – then you may need to have a closer look at your position.
Q: If I have a pensions tax charge as a result of exceeding the AA will I receive a ‘bill’ from HMRC?
A: No. HMRC define tax as being an individual’s responsibility. Therefore, you must ensure that you are familiar with your own position. If you have determined that you have a pensions tax charge, you must declare this through the self-assessment process.
Q: My pensions tax charge is significant. What options do I have to pay this?
A: This is particularly likely in the case of defined benefit schemes as the pensions tax is calculated based on the pension multiplied by the HMRC factor.
Your options are:
- You can choose to pay this tax directly to HMRC.
- If it is below around £2,000, you can also ask HMRC to amend your tax code for the following tax year and they may do this for you.
- You can also look at an option called Scheme Pays. This is where the pension scheme will pay your pensions tax charge for you, removing the need for you to pay the charge immediately. At the point that you retire, a pension adjustment is made to reduce your annual pension. This is how the pensions tax charge is recovered from the scheme. Interest is added and the adjustment will also vary depending on your pension scheme and your age at retirement. As an example a £5,000 scheme pays charge, could result in a reduction of £333.33 per annum from your annual pension (pre income tax).
Q: My pensions tax charge is significant, should I opt out of the pension scheme?
A: This FAQ document is not here to provide financial advice. Everyone’s situation is very different. You should understand your own position before making any decisions. There are however some things that will feed into any opting out consideration:
- If you have a pensions tax charge, it’s because your pension has increased above a certain level. You pay tax on the excess, that is the amount over that level. The pension is continuing to increase, even with a tax charge, whilst you are in the scheme.
- If you use a Scheme pays option to pay a tax charge, this will reduce your annual pension at retirement. Using the example set out in the previous question, for a £5,000 tax charge to have been generated, your pension would have increased by around £3,250 per annum. Scheme Pays will reduce this by £333 per annum. Overall, the pension has increased by £2,900 + per annum*. If you opt out, the pension only increases by inflation.
- Make sure that you have checked your carry forward position before confirming your pensions tax charge. Carry forward allows you to use an unused allowance from the three previous tax years and this can reduce the pensions tax charge.
Q: What is the LTA?
A: The LTA is the limit on the total pension savings for an individual, from all sources, at retirement. If the total pension savings (LTA Value) valued at that time exceeds the allowance, then there may be a tax charge to pay.
It is important to understand that this is the value of the benefits at the time they are put into payment. Certain decisions at retirement change the benefits – such as the age at retirement, more or less cash etc. This will change the LTA value.
If you have a number of years to go to retirement and are not near the current LTA, it is useful to be aware of, but it is unlikely that any actions are currently needed.
Q: The 2021 Budget has confirmed that the Government are now freezing the LTA, should I be worried about this?
A: It is important to keep this in context. The current LTA is £1,073,100. Prior to the 2021 Budget this allowance was increasing in line with CPI. As this is now frozen, we can expect that will not increase any further until at least April 2026.
As with the AA, most people will not be impacted by the LTA. The LTA can impact people differently, depending on their pension scheme.
For defined contribution Schemes, the LTA value is simply the total value of the ‘pot’ and is much easier to see and determine. Using the current annuity rates, for an increasing pension along with a 50% dependant pension, a pot of £1,073,100 will provide a pension of around £18,800 per annum**.
If you are a member of a defined contribution scheme and your total pot at retirement exceeds the LTA, then you will pay tax on the proportion of your pot which is over the allowance. This will usually be at a rate of 25%.
If you a member a of a defined benefit scheme, you don’t have a ‘pot’, you have an annual pension. To assess whether the LTA value exceeds the LTA, the annual pension is multiplied by the HMRC factor of 20. For you to exceed the LTA, your annual pension will need to be £53,655 or more (not including any cash taken).
Where you exceed the LTA, you will pay tax on the excess amount. This is usually at 25%. The pension scheme will pay this tax for you and your annual pension will be adjusted (before income tax) to take account of this. For example, if you exceed the LTA by £20,000 (£1,000 per annum on your pension), you will have a deduction to the annual pension as a result of LTA tax of £250. This is deducted from your pension each year before your earnings are assessed for income tax.
So, the freezing of the LTA may mean more people breach the LTA in the future, and it does provide a further cap on pension benefits. However, we cannot assess the full impact as future inflation rates are not known. We would question how helpful it is to project inflation into the future for the purposes of comparing what the LTA would have been before it was frozen at the current position.
Pensions are a valuable asset. In the case of defined benefit schemes, it is very difficult to replicate the level of benefit outside of the pension scheme. The assessment needs to compare what the pension value would be by continuing within the scheme with opting out. It rarely makes sense to opt out of valuable pension accrual simply to avoid a tax charge on part of that accrual.
NOTE: All pension contributions paid by individuals are subject to tax relief at the highest rate of tax paid for that individual. A 40% taxpayer will currently receive 40% tax relief on their contributions.
The AA and LTA do NOT affect any dependant benefits.
*Net increase in the annual pension for that tax year in real terms. This is based on one particular pension scheme and set of factors. These vary from scheme to scheme and the age of retirement. This is provided for illustration purposes only.
** Based on the LV Annuity calculator, providing a pension at age 60 with a 50% dependant pension, revaluing and with a 5-year guarantee (similar to that of the public sector DB Schemes)
All information provided in this document is for information only and seeks to provide a general overview.
Individuals must review and assess their own individual circumstances accordingly and see additional guidance or advice where required.
The pension scheme and tax rules will always prevail in terms of calculating and paying benefits.