Practical experience of exceeding the pension taper limit

[JuanDB]

Hi,

I’m in the fortunate position of having maximised my pension contributions in prior years, and will this year receive a gross income exceeding £400k. I have no available strategies that I can see to avoid exceeding the maximum pension taper limit and will therefore have an annual allowance of £4000 for 2022/23.

I have already contributed around £8000 to my pension this year and so have exceeded the allowance. I’m seeking guidance on how the excess will be reclaimed, and what contributions to make for the rest of the tax year.

The final section in this document states that the excess is subject to self reporting and that charges relating to exceeding the annual allowance by more than £2000 can be reclaimed directly from the pension. This would seem preferable to avoid a tax bill on self assessment.

https://www.youinvest.co.uk/sites/default/files/AJBYI_Guide_to_annual_allowance_tapering.pdf

Has anyone used this “scheme pays” approach and have any guidance on its use? My provider is Scottish windows.

In terms of contribution for the rest of the tax year, my initial reaction was to stop all payments but on reflection I think there is a better approach.
My employer matches contributions up to 5% and also contributes both ER and ERS NI which is an additional 15.1% on top the 45% tax relief. I haven’t yet done the exact sums but it would seem there is a break even point at around 6-8% personal contributions where the tax reclaimed through the pension is less than the tax on the gross income.

A simple example would be if I contribute £5 gross, my employer matches this and adds 15.1% NI for a total contribution of £11.51. This total would be subject to tax reclaim at 45% leaving me with £6.33 in the pension for my original £5 contribution.

Is this logic sound?

Thanks in advance,

Juan.

[TedSwippet]

No practical experience personally, but a couple of notes ...

The final section in this document states that the excess is subject to self reporting and that charges relating to exceeding the annual allowance by more than £2000 can be reclaimed directly from the pension. This would seem preferable to avoid a tax bill on self assessment.

https://www.youinvest.co.uk/sites/default/files/AJBYI_Guide_to_annual_allowance_tapering.pdf

Has anyone used this “scheme pays” approach and have any guidance on its use? My provider is Scottish windows.

Scheme pays is definitely better, where available. Not using it leads to pure double-tax -- you pay tax on the contribution, and pay it again on withdrawal. In extreme cases, for example in combination with exceeding the lifetime allowance, the tax can reach or even exceed 100%. Using scheme pays leads only to tax on post-tax money; a lesser form of double-tax.

The problem with scheme pays is that it is only mandatory for a scheme where the £40k standard annual allowance is exceeded, and where the tax charge is above £2k. Otherwise it is "voluntary"; that is, a scheme may or may not offer it. So you first need to be very sure that Scottish Win(d)ows will let you use it. There is a fuller explanation than YouInvest's here:

Scheme pays : What are the conditions for scheme pays? - Aegon

In terms of contribution for the rest of the tax year, my initial reaction was to stop all payments but on reflection I think there is a better approach.
My employer matches contributions up to 5% and also contributes both ER and ERS NI which is an additional 15.1% on top the 45% tax relief. I haven’t yet done the exact sums but it would seem there is a break even point at around 6-8% personal contributions where the tax reclaimed through the pension is less than the tax on the gross income.

A simple example would be if I contribute £5 gross, my employer matches this and adds 15.1% NI for a total contribution of £11.51. This total would be subject to tax reclaim at 45% leaving me with £6.33 in the pension for my original £5 contribution.

Is this logic sound?

Maybe sound. The numbers could be fiddly, though. Remember that you pay tax (again) on money drawn out of a pension. The double-tax that occurs when you exceed allowances means that more into a pension does not always translate to more into your pocket.

If I were doing this, I would start with an assumption that the tax on money drawn from the pension will be 30% (that is, 40% after 25% tax-free lump sum) if below the lifetime allowance, but with a worst-case number of 55% for anything that exceeds the lifetime allowance. What you want, then, is for 70% (or 45%) of the amount put into the pension to be larger than what you could simply take instead as current income.

Much care required, in particular around any potential issues with the lifetime allowance. Imagine £100 paid into a pension with a 45% tax charge, no scheme pays, and then drawn above the lifetime allowance for a 55% tax charge. Total tax is 100%. Scheme pays reduces the effective tax to 75.25%; less than 100%, but still far from a winner.

How flexible is your employer? Them simply paying you the pension match as income seems to come out better on these assumptions, even when giving up the entire salary sacrifice NI uplift. Your £5 and their "match" is £5.50 to you after 45% tax. Compare to £4.31, which is your £6.33 after likely 30% tax on pension withdrawal.

Any chance you might retire abroad? If yes, then you have further complications, since it may be hard to impossible to come up with an estimate of the tax rate you will face on UK pension withdrawals. A common (although by no means ubiquitous) feature of tax treaties is that they reserve taxing rights on pensions to the country of residence, rather than the country paying the pension.

[JuanDB]

Ted, thanks for taking the time to post such a comprehensive reply. That is very helpful.

Your comments on “scheme pays” are very clear. I’ve requested a meeting with the SW advisor to clarify their approach. I think this will be the determining factor.

It’s highly unlikely I will exceed the LTA and the majority of my retirement income will come from non-pension sources so I’m unlikely to be anything more than a basic rate tax payer, despite being an additional rate tax payer. Context here is that I started pension contributions late, shortly before a significant increase in earnings which has then constrained ability to make pension contributions.

As a result, tax on withdrawal is not really my area of concern. What I want to avoid is two things;
1: locking money in my pension for 10-12 years for a marginal tax gain
2: getting a significant tax bill this year

I think I have the information I need to make a decision. Thanks again for your help.

Cheers,

Juan.

[TedSwippet]

As a result, tax on withdrawal is not really my area of concern. What I want to avoid is two things;
1: locking money in my pension for 10-12 years for a marginal tax gain
2: getting a significant tax bill this year

While not disagreeing entirely with you, I do think that you should keep a close eye on the tax you will pay on withdrawal. After all, it is primarily the differential between tax relief (actually, deferral) on contributions and tax payable on withdrawal that makes -- or breaks -- the argument for pension saving in the first place. Assuming basic rate in retirement might be optimistic. Your current high salary (windfall?) is something you'll likely need to invest in unsheltered accounts, and at retirement age, a decent level of unsheltered investments can unavoidably spin off dividends and interest that might consume much or even all of your tax allowances.

Also, political risk. With more than a decade of tinkering with the rules, allowance freezing, goalpost shifting, fiscal drag, and other governmental financial shenanigans ahead of you before you can draw from this pension, there's ample scope for problems to arise that you could find it hard to foresee. In my own case, much of my early pension saving was done at 20% tax relief, and the stupid lifetime allowance didn't even exist. Yet in retirement I find myself battling to avoid a 55% tax rate on pension withdrawals. Had I known what was to come, I would (honestly) have saved less into pensions early on, and biased more towards saving outside, ISAs or just general investment accounts, instead.

Anyway, you know your own circumstances and motivations best. Just a note then that there is actually such a thing as too much tax deferral.