PrudentialMay 16 2018

Learn to embrace tax charges

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Learn to embrace tax charges

Pensions were simplified in 2006. One of the new things to come out of this was the annual allowance, an overall limit on the annual amount of pension savings that could be made without a tax charge – the annual allowance charge.  

Since then the annual allowance has changed greatly. It has reduced from over £250,000, making it irrelevant for most, to £40,000, making it relevant for many. 

There are two variations on the theme. The money purchase annual allowance, a £4,000 limit on money, purchase contributions, and the tapered annual allowance, where those deemed to be high earners see a reduction in allowance for all benefit types of up to £30,000.

The tapered annual allowance is complicated and was introduced from 2016 with the policy intention being to reduce tax relief on pensions for high earners. Tax relief is unaffected, but the reduced allowance can create tax charges. It also affects those who are not necessarily high earners.

Whose affected?

There are two limits: an adjusted income of £150,000 and a threshold income of £110,000.  Anyone who breaches both limits loses £1 of annual allowance for every £2 of adjusted income over £150,000, with a maximum reduction of £30,000. 

Both limits are based on the individual’s net income for the year (steps one and two of the calculation in section 23 of the Income Tax Act 2007).   

To get there you add all taxable income received, which would include pension income, salary, dividends (even if they are under £5,000), rental income and the full (not sliced) amount of any bond gains.

Then deduct from this any relief (s24 ITA 2007), which the individual is entitled for the tax year. The most common of these would be trading losses or pension contributions paid to schemes where a claim has to be made (contributions to schemes operating on a net pay basis are taken off when arriving at employment income at step one). This brings us to the net income, that is, the taxable income.

From the net income you deduct the amount of any taxable lump sum death benefit the individual has received in the tax year. This would happen where they receive a lump sum death benefit from a pension scheme where the scheme member died after age 75.

Key points

  • The money purchase annual allowance has changed dramatically since it was introduced in 2006
  • Any unused annual allowance from the previous three years can be carried forward
  • Individuals are subject to the money purchase annual allowance rules under certain conditions

At this point the calculations differ. For adjusted income you add back the value of the individual’s own pension contributions that have already been deducted and also the value of any employer pension provision. The value of the employer provision for money purchase arrangements is the monetary amount of the employer’s contribution. For defined benefit, it would be the pension input amount (broadly 16 times the pension accrued within the pension input period) less the individual’s contribution to the scheme.   

Where adjusted income has the individual’s pension contributions and employer provision added back in, threshold income allows the deduction of pension contributions. This means for threshold income the next step of the calculation is to deduct the gross value of the individual contributions to relief at source schemes; generally this would be contributions to personal pensions and group personal pensions. Once these are deducted, you then have to add back any employment income given up for pension contributions, that is, salary sacrifice arranged on or after 9 July 2015. There are other anti-avoidance provisions in place to prevent people manipulating their income figures.

It is easier to calculate the threshold income first as it is less complicated. Beware an adjusted income quirk. If an employer contribution is made having calculated your available tapered allowance, then it increases your adjusted income, which changes the amount of your tapered allowance. 

Can you carry forward?

Yes. Any unused annual allowance from the previous three years can be carried forward and added to the tapered amount to give an overall annual allowance for the tax year. 

For any year in which an individual breached both income limits the amount of annual allowance that can be carried forward from that year is the amount of unused tapered annual allowance. Given the tapered amount will vary, due to the link to taxable income which will normally vary, the calculations will be more onerous and good record keeping essential.

Can you make the scheme pay the charge?

Sometimes, but the detail is different from the norm. Schemes can voluntarily pay the charge. If requested by the member in the right format, a scheme is required to pay some or all of an annual allowance charge from the pension fund (DC), or by reducing the benefits (DB), under ‘mandatory scheme pays’, where the:

• Liability for the tax year exceeds £2,000 and;

• Pension input amount for the pension scheme for the same tax year has exceeded the standard annual allowance amount of £40,000 – meaning the tapered and/or money purchase annual allowances are ignored.

The quirk for the tapered annual allowance is that, while the tax charge is based on the tapered amount, the scheme can only be required to pay that amount of the charge that is derived by inputs over the standard annual allowance. For example, an additional rate taxpayer has a £10,000 tapered annual allowance and pays in £42,000. The tax charge with reference to the tapered allowance is £32,000 x 45 per cent = £14,400, but the amount with reference to the standard annual allowance is £2,000 x 45 per cent = £900.

Can the MPAA apply too? 

Individuals are subject to the money purchase annual allowance rules where they have flexibly accessed their pension benefits and have money purchase contributions in excess of £4,000.

Under the normal rules when this applies the annual allowance available for all the other benefits in the year, that is, defined benefits and any money purchase contributions made prior to benefits being flexibly accessed, is reduced by £4,000.  

So, for those subject to the tapered annual allowance this amount will be the tapered amount less £4,000, which means it will be somewhere between £6,000 and £36,000. 

What to do about the TAA?

Deciding what to do will be down to myriad factors and a particularly individual decision but there are some key things to think about.  

Many people make additional contributions to use up their annual allowance every year. It may be best to look forward when deciding on current contributions. If you are likely to become tapered in the next three years you may wish to have some unused allowance to carry forward to your tapered year. 

Investment income is a big part of the income calculations. There are some run of the mill income tax planning techniques that can be used to reduce your investment income. Income producing assets can be assigned to a spouse with no tax issues so falling out of your income calculation. Alternatively, ensure you hold income producing investments within a tax wrapper such as a pension, Isa or insurance bond as the investment income within these wrappers is not included in the individual’s tax calculations.

Check whether an individual pension contribution could get you under the threshold income level. People with very high adjusted income could have threshold income at a level where an individual pension contribution could get you under the £110,000 and take the taper away.

Embrace the tax charge. Do not automatically assume breaching the taper is a bad thing. The net of tax benefits accrued may still be a good deal, especially where alternative options are limited. Tax is only bad if the net benefit is not worth it.

Les Cameron is head of technical at Prudential