Paul has a twin brother, Barry, who, amazingly, started working for the same company, on the same day, 20 years ago, and joined the same company pension scheme as Paul did. They even enjoyed the same salary progression.
Barry and Paul do not exist. They are a tenuous way of making a point about the confusing pension legislation, namely the problems posed by the tapered annual allowance.
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For 2016/17 if ‘adjusted income’ is over £150,000, the annual allowance will be reduced via a taper. With the taper in mind, let us look at the twins’ pensions for this year, under a 1/60th final salary scheme with no employee contribution.
- 20 years’ service.
- £80,000 pensionable salary.
- No other income.
- Annual allowance opening amount:
- 20/60 x £80,000 = £26,667
- £26,667 x 16 = £426,667
- Assuming a 2% consumer price index: £426,667 x 1.02 = £435,200
- Annual allowance closing amount:
- The following year, the twins’ pay rises to £90,000.
- 21/60 x £90,000 = £31,500
- £31,500 x 16 = £504,000
- Pension input: £504,000 - £435,200 = £68,800
Their pension input amount from their employer for the year was £68,800 each.
Combined with his salary, this gave Paul an adjusted income of £158,800 and a threshold income of £90,000. As the threshold income was less than £110,000, Paul is not subject to any tapering of his annual allowance.
Barry has always been entrepreneurial and has a portfolio of buy-to-let properties, creating an additional income stream for this year of £15,000. He did some external consulting work, which earned £20,000 for the year. This changed the calculation of his annual allowance and, including the extra remuneration figures, it produced the following:
- Adjusted income: (£90,000 + £68,800) = £158,800 + £20,000 + £15,000 = £193,800
- Threshold income: £90,000 + £20,000 + £15,000 = £125,000
- £193,800 - £150,000 = £43,800
- £43,800 / 2 = £21,900.
- £40,000 annual allowance minus £21,900 tapered reduction = £18,100
The tapered annual allowance would be £18,100, so Barry would be subject to a tapered tax annual allowance tax charge on the excess. This would not have been the case without the additional income alongside his salary.
Barry has never received an annual allowance tax charge before and has done nothing different this year. Their status in the pension scheme has been the same for the past 20 years and they will have accrued the same level of benefit. But some external remuneration, which has nothing to do with the pensioned employment, will slap Barry with a tax bill.
How many people in large defined benefit schemes will have an understanding of the annual allowance (and how many people will be aware of the lifetime allowance), let alone understanding a tapered allowance? If members of such schemes do receive a tax bill, will they know how to pay it? Is it done via scheme pays or self-assessment?
How many will decide the best way to avoid a bill is to leave the scheme?
We never make things easy.
Mike Morrison is head of platform technical at AJ Bell.