The Annual Allowance Charge and High Income Individuals

The ATT technical team has been alerted to a particular issue affecting higher paid earners subject to tapering of the annual allowance who have also incurred an annual allowance charge.  In certain cases, individuals may find themselves having to pay some or all the annual allowance charge personally, rather than from their pension pots.  Members may therefore find the following outline of the position written by an ATT member helpful in order to identify, and alert, clients who might be affected.  

“Where a taxpayer has income in excess of £110,000 p.a. and is a member of a defined benefit pension scheme there is an unexpected twist in the rules that allow the tax charge on the excess of Pension Inputs (PI) (the total of the amount contributed to a pension scheme plus the calculated value of the employer’s contribution based upon the increase in promised benefits) over the Annual Allowance (AA) to be charged to the pension scheme.

The normal AA for 2016/17 onwards is £40,000, but in simple terms if the sum of income plus PI exceeds £150,000 then the allowance (AA) is restricted by £1 for each £2 over £150k subject to a minimum allowance of £10,000.

The rules seem to only allow the tax charge on the excess of PI over £40,000 (the standard AA) to be paid by the scheme leaving the balance to be paid by the taxpayer personally.

The combination of these provisions can leave highly paid individuals with a defined benefit scheme with an unexpected increase in their personal tax bill of up to (30,000 x 45%=) £13,500 per year.

Many of those affected work for the Public Sector, such as BBC; NHS Consultants; GP Doctors; Judges; Heads of Educational establishments, Police etc. Others will be in executive positions in private organisations that offer defined benefit schemes, or may unexpectedly suffer a charge due to a bonus award or other payment to recognise exceptional service. Although highly paid individuals, many will have a life style and financial commitments that would not easily accommodate such an unexpected hit to their cash flow.

The value of the employer contributions will vary from case to case, but could easily be in the range of 30% to 50% of pensionable salary, and in years of increase in entitlement, maybe after a promotion, 70% to more than 100% of salary. If appropriate advice has not been taken, the situation can be made worse by payment of Additional Voluntary Contributions, or use of Salary Sacrifice.

To illustrate the problem, figures often help.

Example One

Take a Consultant with total earnings in 2016/17 of £130,000 and PI of £50,000.

AA of £40,000 would be reduced by (130k + 50k =) £180,000 less £150,000 = £30,000 divided by 2 = £15,000 to reduce AA to £25,000.

PI is £50,000; AA is £25,000 giving a tax charge of £20k @ 40% plus £5k @45% = £10,250.

The scheme could pay, with election by 31 July 2018, PI £50k less standard AA £40k = £10k x 40% = £4,000 leaving the consultant with a bill for £6,000.

Because of the mechanism for payment of tax, this could increase by a further one half as a payment on account leaving a bill on 31 January 2018 of £9,000. Or, because of the carry forward of unused relief this might be reduced for this year only to as little as NIL.

Example Two

Change the total INCOME to £160k, and tax rate to 45% and the charge becomes

AA reduced from £40k to £10k (160 + 50 = 210 – 150 = 60 x ½ = £30k reduction)

PI 50k less AA 10k = £40,000 @ 45% = £18,000 tax due.

Charge to scheme PI 50k less AA 40k = £10,000 @ 45% = £4,500

To be paid by taxpayer 40k – 10k = £30,000 @ 45% = £13,500

With payment on account for 2017/18 of ½ x £13,500 £6,750

Total due 31 January 2018                                                    £20,250

Each case is unique, but many older taxpayers may well decide to retire from their superannuated positions and renegotiate their employment so that the benefits of the employer’s pension contribution is paid to them as salary. This is particularly important where the value of the underlying fund is approaching the Lifetime Limit of £1,000,000.

Again, in simple terms, there is potential for a very high rate of tax to apply.

On contribution £100 excess pension over AA at 45% costs = £45

On withdrawal, excess over Lifetime Allowance is charged at 55%, so:

If the same £100 also exceeded the lifetime allowance at a chargeable event occasion, the charge is a further £55 giving a rate that could be described as (£45 + £55 = £100) so 100%.

Because the £100 contributed would have grown tax free from investment to withdrawal the actual rate would be lower, but not below 55%.”

Additional detail and examples can be found in HMRC’s manuals here.

Pensions are a complex area and members are reminded that following the Professional Rules and Practice Guidelines they must not give advice in regulated investment business activities unless appropriately authorised.  Members may need to refer affected clients to a suitably qualified independent financial adviser for further detailed advice on this issue.