Higher earners snared by the new pensions annual allowance taper face dipping into their own pockets to pay unexpected tax bills of up to £13,500, experts warned.
Financial advisers are sounding the alarm about a little-known rule that restricts payment options for those landed with big tax charges, after inadvertently breaching the newly introduced tapered annual allowance.
From April 2016, higher earners started to be subject to a reduced “tapered” annual allowance, which restricted how much tax relief they could claim for saving into a pension.
In particular, those with total earnings of more than £150,000 have an annual allowance lower than the standard £40,000; above £150,000 the allowance is gradually whittled down to a floor of £10,000 for those with income of £210,000 or more.
Top-rate earners who breached their tapered annual allowance could face a maximum tax bill of £13,500.
Currently, savers can ask their retirement scheme to pay any tax charges related to an annual allowance breach directly from their pension fund, through a facility known as “scheme pays”. This spares an individual having to find the cash from their own savings to settle with the tax authority.
However, experts said HM Revenue & Customs had not made it mandatory for schemes to offer this facility to those who breach the new tapered annual allowance.
“Many individuals may expect to use ‘scheme pays’ to meet any tax charge that arises due to exceeding the annual allowance,” said Sarah Brown, principal with Punter Southall, the pension consultants.
“However, a little-known consequence of the introduction of the tapered annual allowance is that this facility will not necessarily be available to individuals, and if it is available, then the deadline for choosing this option may be much earlier.”
In the worst-case scenario, an individual who had “adjusted income” of more than £210,000 and had contributed the maximum £40,000 into their pension could face a tax charge of £13,500. This is because their earnings would have brought their annual allowance down from £40,000 to £10,000 — and any contributions over that limit would attract a tax charge calculated at the saver’s marginal rate of tax or, in this case, 45 per cent.
Individuals who have incurred annual allowance taper tax charge can still ask their pension scheme to pay the tax bill using the “scheme pays” facility. But advisers said individuals should not rely on their scheme being flexible.
“We have seen schemes that have issued guidance stating they follow HMRC’s guidance, which indicates they will only cover it above £40,000,” said Chris Howerd, pensions technical adviser with Chase de Vere. “I haven’t heard of schemes meeting this on a voluntary basis where the total input is below £40,000. However, that is not to say there aren’t any.
“Also, some smaller schemes may not have any set processes in place for ‘scheme pays’.”
Where pension schemes are flexible on using ‘scheme pays’ to settle a tax charge, they will have much shorter timescales than where members have a right to such an arrangement.
“For example, for the 2016/17 tax year, members may need to decide whether they wish to use ‘scheme pays’ within the next few weeks to allow time for all of the administrative steps to be met by HMRC’s deadlines,” Ms Brown said.
“Higher earners need to take action now, otherwise they may need to meet any annual allowance tax charge out of their non-retirement savings rather than through their pension scheme.”
When the taper was introduced, pension experts described it as “horrific” and “nightmarish” because of complex rules over when it was triggered, making it difficult for some high earners to plan.
The taper works by reducing the annual allowance by £1 for every £2 of total, or “adjusted”, income over £150,000.
However, total income includes not just salary but employer pensions contributions, plus any bonus, dividends from shares, savings interest and income from a buy-to-let property. Unlike an annual salary, many of these extra items are hard to predict at the start of the tax year.
Not all high earners will be caught by the taper. If an individual’s “threshold” income — which excludes employer pension contributions — is less than £110,000, the rules do not apply.
Case study: the full force of the taper
Sarah Brown, pension consultant at Punter Southall, illustrates the problem of the annual allowance taper, using the example of a client named David.
Earning more than £210,000 a year, David made contributions into his defined contribution pension scheme, along with his employer, totalling £40,000 every year.
Due to the introduction of the tapered annual allowance, he no longer benefits from an annual allowance of £40,000 — he will receive tax relief only on the first £10,000 of pension savings for 2016/17.
He must therefore pay tax on £30,000 of his pension savings, or the difference between his £40,000 of savings and his £10,000 tapered annual allowance. This means he owes HMRC £13,500 of tax — due by January 31 2018.
As the contributions to his defined contribution scheme for 2016/17 do not exceed the standard annual allowance of £40,000, David cannot compel his scheme to pay his tax charge.
His employer wishes to help members in this position, so agrees that his scheme will pay the tax for him, subject to reducing his fund by £13,500. But in order for the scheme to carry out the necessary steps by January 31 2018, it requires David to confirm this action by September 30.
However, David only considers this when completing his tax return in October. Further, he did not even realise he had exceeded the new lower annual allowance until he looked at the tax return. He must therefore pay £13,500 from his savings or from his net income. This equates to more than a month of his net income.