Come the 6 April, the tapered annual allowance will be three years old.
Under these rules, people with an adjusted income of over £150,000 and threshold income of over £110,000 have a lower annual allowance (AA).
For every £2 of income they have over £150,000, their AA is reduced by £1. The maximum reduction will be £30,000, meaning that anyone with an income of £210,000 or more will have an AA of £10,000.
Up until now, those clients affected by the taper from the beginning have been able to make pension contributions in excess of their tapered AA by using up carry forward from the previous three years. This will have been calculated by referring to the full standard AA for years up to and including 2015/16.
However, from 6 April 2019 carry forward for all three previous tax years will be the balance, if any, of the individual’s tapered AA. There will no longer be unused allowance available and any contribution in excess of the tapered AA will attract a tax charge.
So what should affected clients do? Are there any alternatives they can look at? Or, perhaps just as crucially, are there any benefits to continuing to contribute to their pension in excess of these limits, and paying the tax charge that comes with this?
It's worth noting here the tapered AA tax charge isn't a charge for bad behaviour. It is just a way for HM Revenue & Customs to recoup tax relief from higher earners.
Instinctively, clients will want to stop contributing to a pension if there will be a tax charge applied. But the question is, should they?
The answer lies in working through a process - this is about more than just the numbers. Let’s look at a case study.
Assessing the options
Michael lives in England and is a company director aged 50 with a salary of £215,000 for 2019/20. He is therefore a 45 per cent taxpayer and his AA is tapered to the minimum of £10,000.
Michael has been making pension contributions exceeding his tapered AA for the last three years by using up some carry forward. His employer pays 8 per cent as standard and contributions are matched on a one-for-one basis up to a further 6 per cent.
Employee contributions are deducted gross from Michael’s pay each month, and Michael expects to retire in 10 years’ time. In all calculations, growth net of charges is assumed to be 4 per cent and we assume that tax charges are taken from the scheme.
If Michael stops his personal contributions but there is still an employer contribution then there would be no cost to him, with £17,200 going into his pension (8 per cent of £215,000 = £17,200). The benefit net of tax charges at retirement would be £20,664, and Michael would pay a tax charge on £7,200 at 45 per cent.
If he continued his contributions, then there would be £43,000 going into his pension (20 per cent of £215,000 = £43,000), based on his employer paying a contribution of 14 per cent and his contribution of 6 per cent.
There is a personal cost of £7,095 as Michael receives 45 per cent tax relief. The benefit net of tax charges at retirement is £41,669, and Michael pays a tax charge on £33,000 at 45 per cent.
He could also decide to follow an alternative route, where he opts out of his occupational scheme and only pays the £10,000 tapered amount into a personal pension. This would give £14,802, based on £10,000 invested over 10 years, with no tax charge. So let’s compare these different options:
- He stays in the scheme with employer contributions and he has his pension pot plus £20,664 after the tax charge
- Employee and employer contributions mean his pot plus £41,669
- He leaves the employer scheme and pays into a personal pension, meaning he has his pot plus £14,802.
On a numbers basis, it's is clear that staying in the scheme with employee and employer contributions means Michael is better off.
What's more, as total contributions to his plan exceed £40,000 and the tax charge is more than £2,000, he can use mandatory scheme pays. This is where the pension scheme pays the tax charge on the individual's behalf with a reduction in benefits as part of this.
For Michael, the main benefit of this is the charge is paid from money which has received tax relief. However, he must remember to declare this in his self-assessment tax return.
The wider issues
But as mentioned before, it isn’t just about the numbers.
If Michael left the scheme he could lose valuable death in service benefits. While these could be replaced by taking out additional life cover, this will come at a cost. There may be further complications in securing cover if he has suffered a critical illness in the past.
Also, if he stops paying contributions then 6 per cent more of his salary will be subject to income tax.
Paying into a personal pension may offer other advantages beyond the income tax implications. For example, it is likely to be less restrictive than many occupational pension schemes in terms of death benefits.
Michael currently pays his personal pension contributions through directly through the payroll. But if they were paid via salary exchange, or salary sacrifice as it's also known, leaving the scheme would result in 6 per cent more of his pay being subject to National Insurance contributions.
Other things for advisers to consider
It may be that your client isn’t in a workplace scheme with the benefit of an employer contribution.
Reducing contributions could be the sensible option, but it's worth discussing whether that extra money will be put to a different use. Is it being invested in another tax-efficient wrapper for example? In the case of a couple, could pension contributions be made for the spouse?
Perhaps the person affected by the taper earns £180,000 and they have a spouse who earns £25,000. The higher earner might have been paying £40,000 in pension contributions, but they could reduce contributions to £25,000 to be within their tapered annual allowance.
They could then pay £15,000 into the spouse’s pension so that on a family basis, the same amount is being paid into pensions. Although the spouse won’t see the benefit of 45 per cent tax relief, that £15,000 of pension contributions for the spouse would make them a non-taxpayer.
The tapered annual allowance can also impact people who are not consistently high earners but have a spike one year.
If we take the example of someone who is about to be made redundant, the employer making a large final pension contribution could push up adjusted income to more than £150,000.
Yet if the employee takes that money as cash, pays income tax on it but then pays into a personal pension, that then reduces their threshold income. If this is reduced below £110,000, it would mean the taper doesn’t apply any more.
The tapered annual allowance will start to bite even more people soon. But by working through a process with your clients, you can help them see that paying tax might not be the end of the world if they end up with more money. Or that by taking a family view, there are still ways to benefit from saving into a pension.
For information and support on the tapered annual allowance to help your clients in the run up to the tax year end, download our factsheets, including a factsheet on the tapered annual allowance.