Pension Tax Relief: A Blow For Higher Earners

Lee Sharpe reviews some of the key changes to pension taxation announced in the summer 2015 Budget.

In the summer 2015 Budget, the Chancellor announced further restrictions on the tax relief for pension contributions made by higher earners. The new rules can affect those earning £110,000 and upwards. This article will cover the basic principles behind the changes. It should be noted that, at the time of writing, this complex legislation is in draft form and may change prior to Royal Assent.

While most readers will be familiar with pensions, it is perhaps worth considering the basics behind them.

Traditionally, a pension has been an investment made over one’s working life to provide an income on retirement, although this has changed quite radically in the last year or so, and the emphasis is perhaps not so much on a relatively fixed income, but more on flexible access to funds, which can potentially include a range of lump sums/income, to suit. 

It is worth noting that the regime basically does no more than delay paying tax on your income: your pension contribution is effectively made tax-free when it is taken out of your hands and put into a pension fund, but it is taxed when it is returned to you as income on maturity.

Basically, when an individual makes a contribution to his personal pension scheme, the scheme is able to reclaim basic rate tax directly from HMRC. For a basic rate taxpayer, this ensures that the contribution is effectively out of ‘exempt’ income.

The scheme doesn’t ‘know’ which of its members are basic, higher or additional rate taxpayers. In all cases, the scheme can reclaim only basic rate tax from HMRC, but taxpayers who have suffered higher rates of tax can reclaim the difference from HMRC through their tax returns – again, leaving them in a position as if that contribution had never been taxed.

Of course, it costs HMRC a lot more to reimburse higher rate taxpayers than basic rate taxpayers, and the government has long perceived that a disproportionate amount of the tax relief has fallen to higher earners – partly because the overall tax rate is higher, but also because higher earners will tend to make larger contributions. The point of the tax relief is to encourage people to save for their retirement but, in the government’s eyes, too much of the tax incentive is being enjoyed by people who can afford to save in their pensions anyway. This will not do, says the government. 

There is basically a maximum amount that someone can invest in a pension and get tax relief, called the annual allowance (AA). In fact, one can physically invest more than that in most cases, but there is arguably little point because a special tax charge cancels out the tax relief which would otherwise arise on the excessive contribution. The AA was reduced from an eye-watering maximum £255,000 a year to £50,000 a year in 2011/12, and then to just £40,000 a year in 2014/15 (although you can ‘boost’ your contributions by rolling up any unused AA from the previous three tax years). Basically, the lower the AA, the less scope to make pension payments before triggering the AA tax charge.

Very simply, the new rules, which take effect from April 2016, will taper the AA by £1 for every £2 of ‘adjusted income’ which exceeds £150,000, until the AA reaches just £10,000. Notably, that ‘adjusted income’ is deemed to include most employer pension payments. HMRC says that this will stop people from circumventing the new rules by sacrificing ordinary salary in exchange for employer pension contributions. 

There are, of course, relatively very few people who may fear being ‘dissuaded’ from contributing any more than £40,000 a year to their pensions. But I suspect there will be many more people for whom a £10,000 limit will present a real obstacle – commonly those in the last few years leading up to intended retirement. It is also quite common for employees in defined benefit or ‘final salary’ pension schemes to be unable to avoid triggering an effective hike in deemed contributions above the AA, which could prove very expensive.

There is however an ‘income threshold’ of £110,000. Again simply put, if your income – this time net of personal pension contributions – is at or below £110,000, then this new taper cannot ‘bite’ unless you negotiated to exchange some of your salary after the new regime was announced. Keen-eyed Budget followers will have spotted more than one reference to salary sacrifice: HMRC appears to dislike them. Could it be the lost tax and National Insurance contributions?

Bill earns £150,000 and personally contributes £40,000 to his pension fund. His income having fallen to the new ‘income threshold’ of £110,000, cannot be caught out by the new taper and all of his pension contribution qualifies. He can claim £40,000 x (40%-20%) = £8,000 tax back on his tax return.  If he has unused AA from the last three years, further contributions are possible.

Ben has a salary of £150,000 and, instead of making his own personal pension contributions his employer offers to make a £40,000 contribution, in lieu of the usual annual bonus. The arrangement constitutes a salary sacrifice; Ben’s threshold income is not reduced by any personal contributions and does not protect him from any prospective AA taper. 

Ben’s ‘adjusted income’ is the combination of income and employer pension contributions, i.e. £190,000, so exceeding the new limit of £150,000 by the amount of the contribution (assuming Ben has no unused allowance brought forward). The allowance is tapered at a rate of 50% to result in an excess contribution of £20,000, subject to the special AA tax charge. As I said earlier, the legislation is new and so far only in draft, but based on my understanding of the regime, the combination of Ben’s loss of tax-free personal allowance, the resulting special AA tax charge and the 45% additional rate will end up costing Ben around £20,000 in tax. He may not be overjoyed at the employer’s apparent generosity (although, in some cases, part of the tax could be borne by the pension fund). 

As described above, the UK ‘EET’ pension regime is supposed to postpone the receipt of income, and paying tax thereon, until the pension investor retires. Given these latest changes, it seems that the Government is trying to actively discourage higher earners from using pensions: it is not so much ‘EET’ as ‘TET’ – a substantial pension contribution is largely taxed on the way into the fund, and although the fund may still grow tax-free, it may be taxed again on the way out, as pension income. Who wants their income taxed twice?

Hopefully, this article serves as a warning of the potential risks for higher earners in making substantial pension contributions, and particularly in terms of arranging employer contributions, following the summer Budget. Anyone who thinks they might be affected should consult a suitably qualified professional.