The March 2021 budget froze the pensions lifetime allowance (LTA) at £1,073,100 until 5 April 2026. This, coupled with the modified annual allowance (AA) tapering-down rules from 6 April 2020, expose pension scheme members to the risk of special tax charges severe enough to cancel out (or worse) the tax reliefs on pensions savings.
Scheme members must navigate two “moving targets” to avoid triggering these charges:
- the “AA testing” of pension contributions/accrual – in many cases, the member won’t know until the end of the tax year what their personal AA (nor, in the case of an employer-run scheme, the total amount of contributions/accrual) will be; and
- the “LTA testing” of future pension scheme distributions – the member won’t know how big the eventual distributions will be, as this depends on future investment growth within the pension scheme etc.), nor the precise level of their LTA at that time.
- Additionally, employers should be aware that certain reward actions or events can complicate, or prevent, employees managing these risks.
(1) AA capping
Where pension contributions/accrual exceed an individual’s available AA:
- they will be subject to the annual allowance charge (AAC) at their marginal tax rate on the “AA excess” –effectively “clawing back” the income tax relief they would otherwise have obtained; and
- they won’t receive credit for the earlier AAC as and when pension scheme distributions are taxed – effectively resulting in “double” taxation. As the AAC can be up to 45 percent and any eventual “LTA excess” benefits can be taxed at 55 percent (or even more), the member could end up paying tax at 100 percent plus.
Although the standard AA is £40,000, individuals with (essentially) annual UK taxable income exceeding £240,000 will be tapered-down, in some cases to an AA of only £4,000.
What does this mean for employers?
In many cases, an individual can’t be sure before the tax year ends just how tapering-down will impact them.
Employers should therefore be aware that certain reward actions or events could have a massive impact on the individual’s personal AA level, and may also result in contributions to/accrual under an employer-run scheme being increased.
- Salary increases;
- discretionary bonus awards;
- share-based payments subject to income tax (either knowingly, or unintentionally where a disqualifying event or plan defect renders a tax-advantaged award non-qualifying); and
- cash cancellation of a share-based award e.g. employee share options (sometimes a go-to ‘administrative easement’ on certain M&A transactions, but the tax treatment and pensions issues should be considered.)
Furthermore, complicated rules mean that the pension contributions themselves may increase or reduce the level of tapering-down. In certain circumstances, contributions made under salary/bonus sacrifice arrangements may have a particularly detrimental impact.
Whilst an individual could delay pension contributions until the end of the tax year, this is often impractical, as the rules of an employer-run scheme often require regular contributions. Unfortunately, “AA excess” contributions cannot be refunded, even where they appeared to be within AA limits when made.
An individual can, however, carry-forward unused AA from the past three tax years in certain circumstances – but careful planning is required.
(2) LTA capping
Where distributions from a pension scheme exceed an individual’s available LTA:
- they will be subject to the lifetime allowance charge (LAC) at either 25 percent (plus income tax) or 55 percent - even if resident outside the UK, the LAC applies notwithstanding any applicable double tax treaty; and
- the facility to take up to 25 percent of scheme benefits free of tax will be reduced, with only 25 percent of benefits within the individual’s available LTA being eligible.
The LAC can also, in certain circumstances, be imposed:
- even where no payments are made to the member (e.g. a member’s entire pension scheme funds may be “tested” against their available LTA when they reach age 75); or
- following an individual’s death – making employer provided life assurance benefits via an excepted group life policy rather than via a pension scheme a potentially attractive option.
Accordingly, individuals need carefully to consider their pension contribution/accrual levels having regard to the potential risk of a later “LTA excess” – this may happen even where contributions/accrual never exceed the AA limits.
Individuals who have previously registered for some form of LTA protection are potentially in an advantageous position. But individuals with LTA fixed protection should be careful to avoid inadvertently losing this by making future pension contributions (as can easily happen where e.g. an individual fails to opt-out of the pensions auto-enrolment requirements) - even joining a new “death benefits only” scheme could sometimes result in loss of protection. Also, individuals who work or worked abroad should consider whether they’re eligible (within the prescribed time limits) to apply to HMRC for the “international” LTA enhancement.
(3) Final thoughts
It’s now easy for even moderately wealthy individuals to fall foul of the AA and/or LTA limits – in which case, they could be worse off than if the pension contributions had never been made.
A salary increase, bonus, or taxable share based payment may not only “push” the employee into a higher tax bracket/jeopardise the individual’s personal allowance, but may also land them with unexpected AAC and/or LAC liabilities. Members of defined benefit pension schemes – which typically provide generous benefits and for which “AA testing” is related to benefit accrual levels rather than the contributions paid – should be particularly wary.
Corporate transactions, for example a sale of the company, could trigger significant cash bonuses and/or taxable share-based payments. Key management participants might not feel their hard-earned reward is quite so good if it lands them with unexpected pension tax risk – so employers should take care to factor in this AA impact where it applies. Employers should also check the company’s pension scheme rules to determine whether any discretionary bonus payment needs to be treated as pensionable earnings, giving rise to a need for further employer pension contributions.
On the plus side, pensions tax relief continues to be a valuable facility. With careful planning substantial pension savings can still be made.
Finally, where there is some “international” angle (i.e. where UK tax-relieved contributions are made to a non-UK pension scheme, or where a member of a UK pension scheme works abroad), the potential legislative concessions and planning opportunities are often much greater (e.g. in certain circumstances, not all the UK tax-relieved contributions made to a non-UK pension scheme are subject to AA testing). Careful forward planning is essential.