What are my options if too much has been contributed to my pension?
Reforms to pensions in recent years have increased their attractiveness in terms of the death benefits and the flexibility of how income is drawn in retirement. However, to balance the books, the government have also reduced the Lifetime Allowance (value of pension fund that can be drawn without suffering a tax charge) and limited the amount you can contribute annually to pensions.
Annual Allowance Excess Charge
The standard annual allowance has reduced to £40,000, with the allowance “tapered” down to as little as £10,000 for high earners (those with earnings and contributions in excess of £210,000 p.a.). Excess contributions can attract rather than relieve tax at rates of up to 45%. This liability is known as the Annual Allowance Excess Charge.
Careful monitoring and planning can often avoid such excesses by managing net income, reducing contributions or using unused allowances from the previous 3 tax years. However, for the highest earners, those with large employer contributions or addition accrual within a defined benefit pension which are out of their control such excesses are becoming an increasingly common and unpleasant surprise.
For example, if you contributed the standard annual allowance of £40,000, but had a reduced allowance of £10,000, your excess would be £30,000. This would be taxable at 45% resulting in a charge of £13,500. Given the nature of defined benefit pension accrual, you may not know the deemed level of contribution until it is too late. Importantly, HMRC does not allow for contributions to be refunded.
As with most areas of personal tax, it’s worth noting that you as the individual are responsible for declaring and settling the tax. Because the liability arises from pension benefits, you can potentially elect for the Annual Allowance Excess charge to be settled from your pension scheme, rather than settling it via your tax return. However, there are certain conditions that need to be met:
Mandatory Scheme Pays –
- The Annual Allowance tax charge for the tax year across all pension schemes is greater than £2,000.
- The pension input amount to the scheme the charge is to be taken from is greater than £40,000 (i.e. the standard annual allowance) for the same tax year.
If, however, the liability arises from a tapered annual allowance, or due to contributions to more than one scheme then they are not obligated to offer scheme pays.
It is always worth asking the question as some schemes are more accommodating than others and offer a voluntary option.
How is the tax deducted?
For a defined contribution pension, the tax is simply deducted from the pension fund value.
For a defined benefit scheme, the calculation is less straightforward. As there is no physical fund value, the scheme pays on your behalf and in effect apply an IOU which reduces your future pension income. This loan will attract interest, generally linked to inflation, and this will accrue until you retire. The longer the term, the greater the potential impact of this accrued interest. Different schemes apply different rates of interest and calculation factors when reducing the income, so analysing the attractiveness of the available options is crucial.
One silver lining for those with Lifetime Allowance issues is that deductions from your pension will help to reduce the associated liability for that tax.
If the schemes will not pay on your behalf, you do not apply in time for the deadline or you would rather preserve your benefits, you can always settle the tax via your tax return. However, this will be from income you have already been taxed on.
As with so many situations, prevention is better than cure. Where possible, such excesses can be managed and minimised via suitable planning. If unavoidable, then careful consideration should be given to whether Scheme Pays is available and indeed appropriate given your circumstances and the terms of the scheme.
The calculations and considerations in this area of pension planning are complex and your adviser can help you make an informed decision on how best to address these.
The content of this article is for your general information and use only and is not intended to address your particular requirements. It should not be relied upon in its entirety and shall not be deemed to be, or constitute, advice.