What is it? And do you care?

Back in the olden days – OK, before 2011 – you could pretty much put as much as you liked into your pension. And get some juicy tax relief on it, equal to your top rate of tax.

So, if you earned £60K, you were a Higher-Rate taxpayer. Put some money into your pension and WHAM! 40% tax relief right there and then, from HMRC. 😎

So far, so good.

But there was a problem. The government of the day – in a post-recession bid to collect more taxes – realised all those pensions tax reliefs were costing the Treasury a LOT of money. Indeed, where people were earning good money and putting huge amounts straight into their pension pot, the gov’t hardly saw a penny of income tax on that.

So in 2011 they put a cap on the amount you could put into your pension and still get tax relief on.

The original cap was £50,000 per year, and that soon came down to £40,000, but from 23/24 tax year it’s now at £60,000.

But will that affect me?

£60,000 of annual pension contributions still seems like a lot. And for most people, it is.

If you’re in a “defined contribution” scheme – where you put money into a pot with the aim of using that put to purchase an annuity when you retire…then the amount you put in each year is entirely in your own hands. Simples!

All private pensions, and most workplace pensions, are defined contribution. Sometimes they’re called money-purchase or retirement annuity schemes. Same thing.

If in the tax year your gross pension contributions (i.e. physical cash put in by you and your employer PLUS the tax relief added by HMRC) stay below £60K, you’re probably home and dry – but see below about “tapering”, just in case…

What about NHS pensions?

Here’s the rub. With a final salary/career average (aka “defined benefit”) pensions, there is no “pot” of money with your name on it. Instead, you make pension payments to your employer each month, in return for an agreed annual pension when you retire.

Whilst this famously affects NHS and public sector staff – who represent about 1/3rd or our client base, so you’re in good hands here – there are a few private employers out there who still offer final salary schemes.

Defined benefit schemes give us a problem for calculating how much you’ve put into your pension – because neither you, nor your employer, has actually put ANYTHING into your pot.

Fun fact: the deductions you made in your last pay packet are actually going towards paying the pensions of the generation of staff before you. Today’s trainees will be funding your retirement…

Instead, there’s an arbitrary calculation to be done, where we take the value of your annual pension at the end of the current and previous tax years, take the difference, and multiply it by a certain factor (depending on the scheme), and adjust for inflation.

This gives a notional value for the growth in your pension scheme, aka “Pension Input Amount” or PIA. If it’s over £60K…you may have a problem. 🙈

As you progress through your career, each pay rise will cause an ever-increasing jump in your PIA. This is more pronounced on the older schemes – 1995 and 2008 – and less of an issue for the 2015, which is a career-average rather than strictly final salary.

Naturally, for those who are in both schemes, there’s some extra work involved to combine the figures.

By way of a VERY simple example, let’s say you’ve been in the NHS pension scheme for 30 years, and you’ve accrued 30/80ths of your current salary of £70K. Your annual pension would be worth £26K a year, and the notional value of your pension pot would be £500K.

Next year, you increment to the next band, at £80K – now you’re on for a pension of 31/80ths of £80K, which is £31K. The notional pot value, however, is now a massive £590K.

That’s a jump of £90,000. So, all other things being equal, you’re in line for a pensions tax charge of more than £12,000 (being £30,000 @ 40%). 😱

But, you MAY have a get-out-of-jail-free card, if you’ve got unused allowances:

Pensions Allowance Carry-Forward

The gov’t isn’t ENTIRELY out of touch with the public sector. They understand that the growth in your pensions benefits isn’t linear – some years you might just have a small change, leaving most of your £60K allowance unused. And every few years when you go up a band, you get a huge PIA for that year alone.

Therefore, when calculating your pensions tax charge, you’re able to consider any unused allowance for the previous THREE tax years, and roll them forward. So if last year your PIA was £50K, and this year it’s £70K, we can roll forward the unused £10K against this year and Bob’s your uncle. Phew!

The rules on which years must be used and in what order are strict, so you need to take care to get this right…

And the eagle-eyed of you will have noticed this is only partially helpful to those at consultant levels where your salary is flat for four years and then increments in the fifth…it’s likely some of your unused allowance is out of reach 😢

Calculation of unused allowance is complex and each year relies on the previous years’ figures as a starting point. It’s also something which a lot of accountants don’t bother to look at for you – which could cost you thousands in unnecessary pensions tax charges when it comes to it.

Make sure your accountant is well versed with final salary and defined benefit schemes. Based on the clients who have joined us from other firms, not many accountants truly understand all this. 🤦‍♂️

Annual Allowance Tapering

By this point, I’ve written “£60K” a dozen times. You get the message. It’s USUALLY the magic number for all of this. But with one exception: people earning £260K+ 😬

If this is you…I’m afraid the gov’t aren’t so helpful here. Where your total income is over £260K then you MIGHT start to lose some of that allowance, at a rate of £1 for every £2 of additional income.

Note we’re taking about ALL your income here – NHS salary, private clinic fees, dividends, rental profits, and so on.

So for example if your total income is £300K, your Annual Allowance becomes £40,000 instead of £60,000.

And just for good measure, HMRC’s measurement of total income for tapering purposes is slightly different to total income on your tax return – so, another headache for your accountant, but that’s what we’re here for.

Although it can work in your favour, as there’s various things which can actually DECREASE your notional income here – so prior planning is essential. Speak to your accountant before the end of the tax year – we don’t have a time machine if you leave it too late.

The Pensions Tax Charge

If you’ve exhausted all of the above options and you’re still over the allowance, I’m afraid it’s time to pony up. Sorry.

The charge is calculated, and paid, through your annual Tax Return. In broad terms, it’s calculated by multiplying your pension “excess” by your top rate of tax.

So, for example, if you’re a 40% taxpayer and you’ve gone over your allowance by £15K – after we’ve made sure all avenues have been exhausted for you – then it’s going to cost you £6,000.

Scheme Pays

But what’s this? One last glimmer of hope before you get the chequebook out?

Yes! Where you have a pensions tax charge to pay, most defined benefit schemes will pay the charge on your behalf, and deduct it from the value of your benefits when you retire.

So whilst you still technically pay it, it won’t affect your bank balance for another 10, 20 or even 30 years, depending on your retirement date.

There are some criteria required to qualify for this, and some strict time limits, but we can help you navigate those.

You (or your accountant) will still be responsible for calculating your allowances and the tax charge itself, and reporting to HMRC that the scheme has paid it on your behalf, but this tends to be the best outcome for those who are caught up in all of this.

And it’s not something a lot of firms are familiar with, so if your accountant tells you that you’ve got to pay a pensions tax charge…give us a call before you write the cheque. Just in case…

Next Steps

If from the above you’re well below all the thresholds and pensions tax charges are something that are unlikely to ever be an issue, great.

But if it’s looking like you’re getting close, or (worse) you’ve had a letter from the NHSPA telling you that you’re well over the allowance for the last tax year, get in touch with our NHS pensions expert Peter Watkins – head to www.blue-penguin.co.uk/contact