Techzone

More pension savers have faced an annual allowance (AA) tax charge since the introduction of the high income taper in April 2016. So what are the traps clients fall into and can forward planning help avoid them and mitigate any charge?

Official statistics* show a threefold increase in the number of individuals reporting an excess in their AA through their self-assessment in 2016/17 when the high income taper was introduced. This is not surprising, given that some higher earners have seen their AA cut to £10,000. And many may have been caught because they were unaware that their income had breached the thresholds.

How the tapering works

Tapering reduces the standard £40,000 AA by £1 for every £2 of 'adjusted income' over £150,000. Ultimately, the AA could be tapered down to £10,000 for anyone with 'adjusted income' of £210,000 or more.

However, it may be possible to reinstate the full £40,000 allowance by making use of carry forward. AA taper won't apply if 'threshold income' (broadly, total income less individual pension contributions) is £110,000 or less. So a large individual pension contribution, potentially using unused allowances carried forward from the previous three tax years, can bring 'threshold income' below £110,000 and restore the full £40,000 allowance. And some of it may attract 60% tax relief too (or more for Scottish taxpayers).

Understanding what counts as adjusted and threshold income

It's important to understand what counts as 'adjusted' and 'threshold' income - and the moving parts that can affect a client's AA. Both start from the same basis of total income from all sources including savings and dividends. But pension funding is treated differently under the two definitions, which can be the key to effective planning.

• Adjusted income is broadly total income plus any employer pension funding. This is relatively easy to identify for money purchase schemes but less so for defined benefits. For DB, the employer contribution is valued as the total pension input amount less any employee contribution.
• Threshold income only includes an addition for employer contributions where they're part of new salary (or bonus) sacrifice arrangements made after 8 July 2015. Any individual pension contributions are deducted to calculate threshold income. So making an individual pension contribution can help avoid AA taper.

These income definitions can easily catch out the unwary. And for some the choice between making payments as an employer contribution (either as a business owner or as salary sacrifice) and making an individual contribution can make a big difference.

Here are five potential traps which can catch out high earning clients.

1. Redundancy payments

The first £30,000 of a redundancy payment is tax free and does not count towards adjusted or threshold income. However, in addition to any redundancy payment in excess of £30,000, any payments in lieu of notice and accrued holiday pay will count towards both adjusted income and threshold income.

As a result some clients who want to increase their pension funding by using some of their redundancy payment could be faced with a reduced AA. Especially if they have new employment lined-up.

The problem can be made worse by sacrificing some of the taxable redundancy payments for an employer pension contribution. The new salary sacrifice arrangements will count as threshold income as well as adjusted income.

However, an individual contribution will reduce threshold income. If large enough, it could bring it below £110,000 - reinstating the full £40,000 allowance.

It is worth noting that the actual termination payment for loss of service (excluding elements such as holiday pay and payments in lieu of notice) are not currently subject to NI and would not therefore generate any NI savings from a sacrifice.

2. New salary and bonus sacrifice arrangements

There is no AA tapering if threshold income is £110,000 or less. This is broadly the client's total income less any contributions they pay personally.

Employer contributions are generally ignored for threshold income. However, they are included in threshold income where they are paid as a result of a new salary sacrifice arrangement which commenced after 8 July 2015.

An existing sacrifice arrangement which increases because it is linked to a percentage of pay won't normally affect threshold income. However, if the terms of the salary sacrifice change or the employee decides they would like to give up more of their salary, this could increase threshold income.

Bonus sacrifice normally requires a fresh agreement each time a bonus is awarded. This will always be regarded as a new sacrifice and add to the client's threshold income.

In some circumstances, taking salary/bonus and paying an individual pension contribution may deliver a better outcome - even if this means forgoing the NI savings associated with salary/ bonus sacrifice. With the help of carry forward, it may be possible to reduce threshold income below £110,000.

3. Buy to let mortgage interest relief changes

Tax changes for clients with buy to let properties could see more of their income counting towards the tapered AA. The way mortgage interest relief is given on second properties is changing. Mortgage interest will cease to be applied as a deduction from profits. Instead, tax relief will be in the form of a 'tax reducer', i.e. a reduction from the ultimate tax bill.

This means more of the income they receive from buy to let properties will count towards both the adjusted and threshold income figures, which could result in further AA tapering.

The changes began from April 2017 and are being phased in over four years. 2019/20 is the last tax year in which some mortgage interest can be deducted from rental income before tax. Currently 25% of interest is allowed as deduction before tax and the remaining 75% of the interest receives a 20% tax reduction. From April 2020 the full rental income received will be included for adjusted income and threshold income purposes.

4. Bond gains

Making a pension contribution can be a great way to reduce the tax on bond gains. The basic and higher rate bands are extended by the gross amount of any individual contributions. If the top sliced gain can be kept within the extended tax band it can avoid tax at either higher or additional rate.

However, bond gains could lead to a reduction in the AA. The full gain counts towards both adjusted and threshold income to determine if AA will be tapered. The impact can potentially be reduced if it is possible to spread the bond surrender over different tax years such that tapering is minimised or avoided altogether, increasing scope for more pension funding.

5. Scheme pays may not be an option

When there is an AA tax charge to pay, clients can ask the scheme to pay it. But this may be at the scheme administrator's discretion if the charge is due to AA tapering. This means the deadline for making a request to the scheme could be up to 12 months earlier than if the scheme has a mandatory obligation to pay.

If they do not agree, clients will have to pay the charge from their own resources.

* Source: https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/744152/PEN7.pdf