A look at the options for avoiding the tax charge that comes with being over the allowance
John, aged 58, had been in continuous employment from the age of 16 but, in early 2018, a company he had recently joined went out of business. As he was not entitled to any redundancy pay, he started accessing his pension savings through a series of uncrystallised funds pension lump sum payments without advice.
John received a letter from his pension scheme on taking his first UFPLS, stating he had flexibly accessed his pension benefits, meaning he is subject to the money purchase annual allowance. He has been offered a new job with a salary of £80,000. His employer offers a net pay, money purchase pension scheme; if John puts in 4 per cent, his employer contributes 6 per cent.
John thinks he will be fine as his contributions to the scheme will only be £3,200 per annum (£80,000 x 4 per cent). But he has arranged a meeting with an adviser for peace of mind.
The MPAA restriction
The adviser tells John that all contributions – made by him, someone on his behalf and his employer – count towards the MPAA. So a total of 10 per cent of his salary – £8,000 – would count.
As such, he will be £4,000 over the MPAA and facing a tax charge on this of £1,600 (a £4,000 excess added to his other income sits wholly in the higher rate tax band of 40 per cent). John is confused as to what to do now, as he always thought contributing to a pension was a good idea, especially as there was money being paid in by his employer.
His adviser gets a letter of authority to speak to the employer and says he will crunch some numbers to work out the best course of action.
After speaking to the scheme, John’s adviser tells him he has worked out the best course of action. He has considered the following options.
Option 1: Staying in the scheme and paying the tax charge
The adviser has checked and voluntary scheme pays is not an option for John, so he would have to settle the MPAA charge via self-assessment. While the cost to his take-home pay to put in 4 per cent is £1,920, he will also have to pay the charge of £1,600. So getting £8,000 in his pension costs £3,520.
The adviser has assessed that John will be a basic rate taxpayer in retirement with no lifetime allowance issues.
With 25 per cent tax-free from the pension as pension commencement lump sum, the net benefit to John will be £6,800. Ignoring any growth, this is a net return of £3,280. Not too bad a return, although he will need to find a way to fund the £1,920 charge.
Option 2: Opting out
If John opts out of the scheme, the £3,200 he was putting into the pension becomes taxable at his marginal rate. So he gets an extra £1,920 in his bank (after tax, it is subject to National Insurance either way). This is not as good as the net benefit from the first option.
Option 3: Reducing the contributions to MPAA limits
John’s adviser has found out from the employer he can reduce his contributions to 2 per cent and it will pay 3 per cent. Based on this, he would have to opt out of auto-enrolment as the total contributions would be too low to meet the qualifying criteria. Handily enough, 5 per cent of John’s salary is £4,000, so there is no MPAA breach.
The net cost to John is £960, to get £4,000 into a pension. The net benefit for a basic rate taxpayer taking the benefits will be £3,400, a net return of £2,440. Again, not bad but lower than option one.
John will not contribute as much to his pension, giving an extra £1,600 as salary.
After tax, that is £960 more in his bank account, making an overall net benefit to John of £3,400.
As he was already expecting to have spent this money, he could use this to save with his unused Isa allowance.
Potential salary increase
Based on options one and three, the costs to the employer for salary, pension contributions and NI are £94,648.78 and £92,248.78 respectively. By taking option three, the employer saves £2,400 before corporation tax.
John could ask his employer whether it will consider increasing his salary by £2,108.96 if he alters his pension contribution, factoring in the employer’s NI (£291.04).
That extra pay gives John a net benefit (after tax and NI) of £1,223.19, on top of the above calculations.
Of course, not all employers will do this, but as my dear departed mother used to say, “nae cheek, nae chance”. Or for those not familiar with Scottish idioms, there is no harm in asking.
So the adviser recommends option three. But it is only after analysing the true net benefit that the advice could be given. Different matching employer contributions will give different results.
One size never fits all for this, but one process does. It is only then that the net benefit can be worked out to know if the juice is worth the squeeze.
Mark Devlin is senior technical manager (pensions) at Prudential