The impact will depend on their individual circumstances. The initial reaction for many will be to stop paying into their pension if this will lead to a tax charge on savings in excess of the LTA.
But a bigger tax bill is not necessarily a bad thing if the net returns available through the pension are still greater than saving elsewhere.
So what are the key considerations?
| Stop funding | Continue funding |
| Pros: reduces or eliminates the LTA charge on future savings; eligible for fixed protection on existing savings | Pros: continue to benefit from their employer’s contribution; continued tax relief from personal contributions at highest marginal rate of income tax; investments will continue to grow tax-free |
| Cons: ikely to lose the benefit from their employer’s contribution; personal contributions will need to be invested elsewhere | Cons: savings above the LTA will be subject to an LTA charge of 25% if savings extracted as taxable income (or 55% if the surplus is taken as a lump sum); none of the surplus can be taken as tax-free cash |
Clearly, one of the key elements influencing choice will be the value of the employer contribution. If funding stops, will the employer stop funding too? And if the employer stops funding the pension, will they offer any alternative form of remuneration?
Fixed protection could mean that up to an additional £250,000 of pension funds are free from the LTA charge. And just a single pound of additional funding will lose that protection. So it is clear that there is a trade-off of an increased LTA against the loss of future funding from the employer. Critical factors will be how near the individual is to their expected retirement date and how close their pension funds are to £1m.
The loss of employer funding
Protection might mean that LTA charges are limited or avoided completely. It could also mean giving up on future pension saving. But it may mean giving up on valuable employer pension funding too.
Employer pension contributions are essentially ‘free money’. Even if they suffer an LTA charge of 55 per cent on their entire future employer funding they will still be better off. They are still receiving 45 per cent of something they may otherwise miss out on.
Some employer contributions are only payable if the employee also pays into the scheme. Even so, it could still make sense to continue their own funding and take the LTA charge on the chin to retain the funding from their employer.
Alternative employer remuneration package
The picture may change if the employer is prepared to offer some other financial incentive instead of making pension contributions.
But it depends on what the alternative offer is. Any alternative package will be taxable in the employee’s hands. And the employer is only likely to provide the employee with a cash compensation which equates to the same net cost of the pension contribution (that is, salary sacrifice in reverse). So the amount of additional salary will be reduced in line with the employer’s additional NI liability.
For example, a higher rate taxpaying employee receives an annual employer pension contribution of £40,000. After deduction of employer NI at 13.8 per cent, that would equate to additional salary of £35,149.
But of course, the employee then has both income tax and NI to pay on the additional salary, so the amount they will actually receive would be £20,386.
The table below shows what the employee might get back by investing the net pay of £20,386 over five years into another investment wrapper with the same gross roll-up and achieving a 2.5 per cent real rate of return. Of course, the net pay is greater than the current Isa allowance, but this could still be achieved by spreading across the tax year or using their spouse’s allowance.
| Pension | Isa | Offshore bond | |
| Future value | £45,256 | £23,065 | £23,065 |
| Higher rate taxpayer in retirement | £20,365* | £23,065 | £21,994 |
| Basic rate taxpayer in retirement | £27,154** | £23,065 | £22,530 |
* After LTA charge at 55 per cent (which also equates to LTA charge of 25 per cent + 40 per cent income tax if taken as income)
** After LTA charge of 25 per cent plus 20 per cent income tax on balance
No alternative but to give up personal funding? Think again
There is something that feels slightly uncomfortable about paying personal contributions knowing that an additional tax charge will be applied. What really matters, though, is what you might get back after all taxes have been deducted.
And that will depend upon the tax rate paid in retirement. If income in retirement can be kept at basic rate, personal contributions receiving 40 per cent tax relief even after the LTA charge will achieve exactly the same return as an Isa.
The table below compares what the client might get back in their hand assuming a real rate of return of 2.5 per cent over 10 years for the same net cost of £15,000.
| Individuals | Sipp | Isa | Offshore bond |
| Contributions | £25,000 | £15,000 | £15,000 |
| Fund value | £32,000 | £19,200 | £19,200 |
| LTA charge 25% | (£8,000) | ||
| Income tax 20% | (£4,800) | (£840) | |
| Net amount in hand | (£19,200) | £19,200 | £18, 360 |
And of course, this ignores the position on death with the pension generally being IHT free, whereas both the Isa and offshore bond will form part of the estate for IHT.
It is only natural to think tax charges should be avoided – especially one designed to act as a cap on funding. But it is always important to weigh up all of the options available. And the alternatives will generally have their own tax consequences to be worked through. But do not immediately dismiss the option to ‘do nothing’ and carry on regardless, as it could give the best outcome.
Laws and tax rules may change in the future and your client’s personal circumstances also have an impact on tax treatment.
Dave Downie is technical manager at Standard Life
Key Points
Funding one’s pension is the question facing an increasing number of pension savers in danger of breaching the LTA when it drops to £1m this year
It could still make sense for a saver to continue their own funding and take the LTA charge on the chin to retain the funding from their employer
What really matters, though, is what you might get back after all taxes have been deducted.