A taxing issue indeed.
A common question from our NHS employed clients surrounds the current pension annual allowance (AA), and the rising tax charges being received by their colleagues.
Today’s article explains what it all means, and how with a little planning, these tax charges could be potentially avoided.
What’s the issue?
The issue for members of defined benefit pension schemes (such as the NHS Scheme) is that they have very little control over how much their pension benefits increase in value, in any given year. If you receive a sizeable pensionable pay increase, your benefits will also increase, and especially so for long-serving members of the 1995/2008 Scheme.
Tax charges for exceeding the annual allowance (AA) have been further impacted by the tapered annual allowance (TPAA), which has been in force since the 2016/17 tax year.
What’s the Tapered Annual Allowance?
The tapered annual allowance (TAA) is designed to restrict pension tax relief for high-earners.
There is a two-stage process for testing if the TAA impacts you:
Test 1 = the ‘threshold income’ test
This measures all taxable income, from all sources, less individual member pension contributions. If the total of this sum is below £110,000 no further TAA testing takes place and the higher amount of £40,000 annual allowance is retained.
Test 2 = the ‘adjusted income’ test
If, however, the £110,000 threshold income test is breached, then you the deemed value of the pension accrual is added to the income figure to test for ‘adjusted income’. If that combined figure exceeds £150,000 the AA will be tapered.
This can give rise to potential issues, especially for longer serving NHS members. For example, if a consultant has 30+ years’ service in the 1995/2008 Scheme, and receives a £10,000 pensionable pay increase today, this could potentially raise your pension benefits (in the form of an increased pension input amount – PIA) of circa £70,000.
If the consultant’s income under the threshold test is £109,000, the full £40,000 AA is retained, he will be taxed on the £30,000 excess PIA (£70,000 – £40,000).
If that doctor’s income is £111,000, the deemed income for the adjusted income test is £181,000 (£111,000 plus £70,000 PIA). The AA will be tapered by £1 for every £2 excess, giving rise to a reduced AA of £24,500, meaning tax is now due on an excess of £45,500.
According to a number of press publications, as well as the British Medical Association, these numbers provide sufficient incentive for a rising number of NHS members to decline overtime shifts in an attempt to stay below the £110,000 income level.
For those facing this situation a focus on keeping total income under the threshold will clearly be helpful.
Conventional methods of reducing taxable income can be used, such as making use of the Carry Forward rules. Here, you are able to make additional personal pension contributions, totalling the previous 3 tax years unused annual allowances. Some strategic timing of these contributions could help remove, or minimalize, any AA excess tax charges you could face by reducing your Test 1 threshold income test earnings level.
If a tax charge if inevitable, then you could consider the Scheme Pays rule, which allows you to opt for the scheme itself to pay the tax charge on your behalf (meaning you’re not paying it out of your net earnings).
Scheme Pays works by creating a notional debt account of the tax paid within the scheme, where interest is then added (currently at 2.4% above CPI). At retirement, a factor is used to convert the debt into a pension benefit reduction.
If a tax bill has to be paid, then Scheme Pays will often be a very attractive option as it avoids you having to fund the tax bill immediately. This also has the additional benefit of assisting those breaching the Lifetime Allowance limits, by reducing the value of the pension for that test at point of accessing your benefits.
Applications to secure 2017/18 scheme pays must be made to the NHS scheme by 31 July 2019. Further details are found on the NHS pensions site.
Exit the scheme?
One decision which is highly likely to be in your best interest is to leave/exit the pension scheme. You’d lose out on valuable pension and employee benefits.
However, and in all instances, you should speak with a qualified pension expert before making any decision.
Tax treatment depends on individual circumstances and may be subject to change in future. The value of all investments can go up as well as down. Opinions, interpretations and conclusions expressed in this article represent our judgment as of this date and are subject to change.