Advisers must be on the lookout for clients inadvertently failing to report an annual allowance breach on their tax return
How many of your clients are inadvertently lying to HM Revenue & Customs? Probably more than you think if they are affected by the complexities of the tapered annual allowance when it comes to pension tax relief.
Since April 2016, higher earners have faced a potentially reduced level of annual allowance for pension tax relief.
Those with total taxable income, including the value of any employer pension contribution, in excess of £210,000 can find their annual allowance reduced from £40,000 to as little as £10,000.
But the rules around the tapered annual allowance are so complex that whole seminars are devoted to helping advisers understand how it actually works.
Given that clients are expected to self-declare on their tax return whether they have breached the annual allowance, and given they may consult an accountant (if anyone) rather than a financial adviser before completing that return, how many are actually getting it right? And if they get it wrong, and it is subsequently discovered, how many will face tax bills running into many thousands of pounds?
The level of knowledge required to fill in this one innocent question on the tax return is staggering. The first stage is to work out the level of annual allowance after the tapering has been applied.
To calculate the extent of tapering, people first have to calculate their net income, then their threshold income: that is, net income adjusted for pension contributions and salary sacrifice arrangements.
If this figure is over £110,000, they proceed to the next stage, which is to work out adjusted income: net income plus employer contributions plus some adjustments for tax relief. If the adjusted income exceeds £150,000, they face a 50p in the pound deduction from their maximum annual allowance until it reaches a floor of £10,000.
But the poor taxpayer is not finished there. They then have to work out how much pension contribution to test against the revised annual allowance figure. For defined contribution pensions, this is relatively straightforward; basically, the total amount contributed (gross) by employer and employee. But for taxpayers with defined benefit accrual, the rules are very involved.
In simple terms, the calculation is to look at the change in the value of DB benefits between the start of the year and the end of the year, adjusted for a measure of inflation and multiplied by 16. This complexity means the issue of failing to report a breach of the tapered annual allowance may be a particular problem for higher earning members of DB schemes, such as senior NHS professionals, civil servants and others.
By this point, even taxpayers who had heard of the tapered annual allowance would probably have lost the will to live. And we have not even got onto the issue of carry forward of unused allowances from previous years, including those in which the tapered annual allowance would potentially have also applied.
Be on the lookout
An adviser might well respond to all of this by saying such complexity is precisely why advice is so valuable. And they would be right.
But what if your clients do not use your services to complete their tax return? What if they do it on their own or use an accountant who may not be on top of the subtleties of pension tax relief? Are you confident your clients are not inadvertently storing up future tax bills or worse?
Where DB scheme members incur tax charges because of a breach of the annual allowance, they may be able to benefit from a scheme pays arrangement which avoids a short-term cash flow hit, albeit at the expense of a lower final pension. But it is not yet clear whether DB schemes will be happy to apply scheme pays in cases where the annual allowance breach occurred a year or more earlier and has only just come to light.
In an ideal world, we would not have a tapered annual allowance. If we did, high income in one year would affect the ability to contribute in the next year, which would give more time to work out there was a problem and do something about it.
But, for as long as we retain this absurd in-year tapering of annual allowances, advisers must be on the lookout for clients who may be caught unawares and help them make sure they are not inadvertently failing to report this on their tax return.
Steve Webb is director of policy at Royal London