It all sounds very simple: taxed deferred is taxed saved, as they say. However, in the world of pensions, the existence of the EET system doesn’t actually mean that no tax will be paid until the point of retirement. It also doesn’t mean it is as simple as paying income tax on the amount taken as income. The reality is lot more complex than that, and all the charges that could be applicable should be considered.
Annual allowance charge
The first thing to note about the annual allowance charge is that it is designed to reclaim from the individual any tax relief they have received on pension contributions or accruals over their annual allowance. This should mean that the individual won’t end up out of pocket, because they should have already received the tax relief from the government.
In practice, because of the way different schemes work and the fact that some of the contributions will be made by an employer, it may feel like the result is negative rather than neutral. While these issues can be particularly complex in cases involving a defined benefit pension scheme, most of the time the result is still positive.
The annual allowance charge is a stand-alone tax charge so there is no way to avoid it. The charge has to be declared and/or paid using self-assessment; there is no simplified way of doing this for those that don’t usually complete a self-assessment tax return.
Such charges have increased for many over the past few years due to the introduction of the tapered annual allowance, which means annual allowances could reduce to as low as £10,000 for high earners – if their earnings including pension contributions and capitalised accrual are in excess of £210,000.
It is very difficult for those with variable income and bonuses that are paid late in the tax year to know what their earnings will be, making it hard to determine their tapered annual allowance. Couple this with a DB scheme where the amount of capitalised accrual is also determined by income at the end of the tax year, and an individual can be in an impossible situation when it comes to planning.
But this is where carry forward can be useful. The annual allowance unused in the previous three years can be set against the current year’s pension contributions and capitalised accrual. For some, this can mean no tax charge if it is an unusual year, but for others this flexibility will soon get used up, meaning annual allowance charges will be incurred each year.
The excess contribution is added to the earnings to determine the rate of tax applicable; if it spans two tax bands then the charge will be charged at the two different rates.
Unauthorised charges
Unauthorised payment charges can occur in several scenarios and they should be avoided if possible. Having an unauthorised payment charge essentially means that the rules surrounding pension schemes have been broken and funds have been accessed in a way that isn’t permitted.
If enough unauthorised payments occur in a scheme, the scheme can be deregistered and additional tax charges will apply to the remainder of the assets in the plan. This is rare, but it is something to be aware of for schemes that are not managed by a professional administrator. Most mainstream plans wouldn’t have this issue.
Unauthorised payments generally fall into two categories – member and employer – but the charges are more or less the same.
There is an initial unauthorised payment charge equating to 40 per cent of the unauthorised payment. There is also a scheme sanction charge that would be levied on the scheme; this is also 40 per cent of the unauthorised payment.
However, the scheme sanction charge will be reduced to just 15 per cent if the unauthorised payment charge is paid in full. If only part of the unauthorised payment charge is made, the reduction in the scheme sanction charge will reflect this.
The unauthorised payment charge will fall on the person or entity to have received the unauthorised payment, rather than being taken from the scheme. However, the scheme sanction charge will be paid from the scheme itself.
On top of all these charges there is a possibility of an unauthorised payment surcharge, which only applies if the unauthorised payments exceed 25 per cent of the member’s fund (25 per cent of the scheme for employer payments) within a 12-month period. This means that multiple small unauthorised payments could suddenly result in a large extra charge. Again this charge will fall on the person or entity that has received the payments.
In total, these charges will be 70 per cent of the amount of the unauthorised payment if they all apply in full. This is a real deterrent for anyone wanting to try and bypass pensions rules and access funds before the age of 55.
These charges can also apply to investments made by the scheme, such as a loan to a sponsoring employer that doesn’t meet all the rules for a loan back or isn’t paid back in the correct timescale.
For those that fall foul of scams, these charges could be levied on the individual because they have, in theory, received the payments out of the scheme – despite the reality being they have lost the funds to a scam. This creates a particular problem because the very fact they have lost their pension access may well mean they do not have the funds to pay the charges to HM Revenue & Customs.
LTA charge
The lifetime allowance charge is also designed to recoup tax relief on excess contributions made to the pension schemes. In the unfortunate cases where individuals have had multiple annual allowance charges and a large LTA charge, there could be a negative effect on some contributions. Advice should be taken in these circumstances to try and establish if continuing to contribute is worthwhile.
The LTA charge is tested at the point that benefits are crystallised. This is usually the point at which the funds are accessed and the tax-free cash is taken. However, it could alternatively be on death if the funds haven’t been crystallised before or at age 75. The amount tested each time uses up a percentage of the LTA, and it is only at the point that 100 per cent of the individual LTA has been used that a tax charge will apply.
The tax charge is either levied at 25 per cent or 55 per cent. The 25 per cent tax charge applies where the excess funds remain in the pension to provide an income. The reason it is lower is because it assumes that when the income is taken at a later date it will be subject to an income tax charge. The assumption is that this will be a charge at 40 per cent.
For example, apply a 25 per cent charge to £100,000 and the individual will be left with £75,000. Applying a 40 per cent income tax charge to the remainder would leave £45,000, which would be equal to an overall charge of 55 per cent on the original amount.
The 55 per cent charge is applied if funds greater than the LTA are taken out as a lump sum; there is no further income tax charge on this lump sum and hence a higher charge is levied.
All these charges could make some think that a pension isn’t a good investment, but that isn’t the case. Provided that the investments and payments into and out of a pension are made in the correct way and monitored to ensure they stay within the appropriate limits, their tax efficiency remains intact.
Taking the right advice about pensions and pension schemes is key to avoiding or minimising any tax charges due. The annual allowance and LTA charges may not be easy or possible to avoid in some cases, but opting out of a pension scheme isn’t something to take lightly.
Even with some tax charges applied, the benefits can outweigh the contributions paid in many cases. In addition, members of some schemes will also lose valuable death benefits, such as death-in-service payments, should they leave the scheme. All aspects need to be reviewed before any decision is made.
Claire Trott is head of pensions strategy at St James’s Place Group
