Joe Hawes, Chartered Financial Planner at CBW, London accountants, tax and business advisors, discusses the problems faced by practitioners hit by cuts to the annual allowance and the pensions taper.
This article was written for and first published in June 2018 edition of ‘The Dentist’.
There are several annual tax allowances that we should make good use of, such as cash or stocks and shares ISAs, which shelter savings and investments from income tax or capital gains tax. For those willing and able to accept higher levels of investment risk, Venture Capital Trusts (VCTs) or Enterprise Investment Schemes (EIS) also provide tax incentives whilst investments in business relief qualifying assets provide accelerated shelter from inheritance tax for those who consider this important.
Arguably, the most lucrative allowances are reserved for pensions. Tax relief when you pay in (for employers and employees), a potential tax-free lump sum at retirement and tax-free growth within a pension fund for those investing in Additional Voluntary Contributions (AVCs), personal pensions, or self-invested personal pensions (SIPPs) make them an excellent mechanism to save for retirement. However, successive cuts to the annual allowance (the amount you can pay in each year) and the introduction of the tapered annual allowance for the highest earners have made careful planning absolutely necessary to avoid an expensive mistake.
The annual allowance and tapering
Gone are the days when the maximum amount that could be paid into a pension each year was £255,000. The standard annual allowance is now £40,000, which sounds substantial; however, the way in which the NHS Pension is valued means that this can easily be exceeded.
The reason being that contributions to a defined benefit scheme, such as the NHS Pension, are not simply the amount of money paid in. Contributions are based on a calculation of the deemed increase in pension benefits over the course of a scheme year. This can be a complicated calculation, requiring a valuation of the pension at the beginning and end of a scheme year and an allowance for inflation.
Overfunding or exceeding the annual allowance in any given year might be relieved by claiming ‘carry forward’ or in other words using unused annual allowances from up to three previous tax years against the current year’s contributions. This is a valuable facility and might alleviate the problem for one or two years, but it’s unlikely to be a long-term solution.
This is further complicated by the tapered annual allowance, which came into force for tax year 2016/17. This reduces the amount of benefit accrual allowed to an individual’s pension arrangements if the ‘threshold income’ is over £110,000 and the ‘adjusted income’ is over £150,000. This reduces the standard allowance by £1 for every £2 of income over £150,000 to a minimum of £10,000 for those with an income of £210,000 per annum or more. However, this does not simply apply to income earned within the NHS, but almost all types of income, including:
- earnings from private practice
- dividends or bank account interest
- pension contributions made on your behalf by an employer.
The latter is extremely important since employer pension contributions are not included in a tax return or P60, therefore, can easily be overlooked.
As we are now into the third year of the tapering rules, many practitioners will have used up most, if not all, unused allowances. This could result in substantial annual allowance charges in 2017/18 and thereafter.
What happens if I exceed the annual allowance?
Annual allowance charges are borne by the scheme member even when contributions were made by an employer. The charge reverses any tax relief given, therefore, the excess contribution effectively suffers income tax; most likely at the 40% or 45% rate. In some circumstances, it’s possible to use the ‘scheme pays’ rules, which allow annual allowance charges to be settled via a reduction in pension benefits. This may be preferable to settling the tax bill from your own pocket; however, it involves a permanent charge against your pension.
What causes overfunding?
By simply having high earnings and many years’ service in the NHS, practitioners can exceed the annual allowance, especially where tapering applies. Other factors can also lead to a higher than usual pension accrual, such as paying into added years contracts or Additional Voluntary Contribution (AVC) funds or private pensions. In addition, overfunding can be caused by significant increases in pensionable pay, for instance, a promotion or reaching an increment threshold or achieving a Clinical Excellence Award.
Annual allowance charge
Practitioners can find out whether any ‘carry forward’ is available and avoid an annual allowance charge when the following calculations are made:
- Threshold income and adjusted income for tax years 2016/17, 2017/18 must be determined and estimates made for 2018/19
- Personalised annual allowances can be calculated from this
- These can be set against the pension input amounts for each year to check how much allowance has been used and whether any ‘carry forward’ is available
- Finally, an estimate should be made as to whether overfunding is likely in the current year, allowing for potential increases in earnings or other enhancements.
The information required to make these calculations can’t be found in a single document. A combination of Total Rewards Statement, P60, tax-return and possibly self-employment or partnership accounts are required. Seeking guidance from an IFA who is familiar with the pension scheme rules, the relevant tax rules and is accustomed to dealing with multiple sources of information is essential to avoid the pitfalls of an annual allowance charge.
The current tax year began in April and a new set of allowances apply, but these will gradually be used up as the months pass. It may be too late to reverse actions taken and contributions made prior to April 2018, but acting now can ensure that expensive mistakes are not repeated or compounded.