Simon Nicol explains why some senior doctors are refusing to work extra shifts for fear of facing huge pension-related tax bills, while others are retiring early for the same reason.
Although the annual allowance capping rules, which are causing a lot of this anguish, have been around since 2016/17 many members of defined benefit schemes (final salary pensions) are only now realising the tax consequences. In some cases, it is too late to take appropriate action.
What is the issue?
The problem for doctors, and indeed all members of defined benefit schemes such as the NHS Scheme, is that they have little control over how much their pension benefits increase in any given year. If a substantial pensionable pay increase is received, benefits will also increase substantially, especially for long-serving members of the 1995/2008 Scheme.
Tax charges for exceeding the annual allowance (AA) have been exacerbated by the tapered annual allowance (TAA). This has been in force since 2016/17 and is designed to restrict pension tax relief for high earners.
The issue with the TAA is the two-stage testing process. The first ‘threshold income’ test measures all taxable income, from all sources, less individual member pension contributions. If this is below £110,000 no further TAA testing takes place and the £40,000 AA is retained.
If, however, the £110,000 threshold is breached then the deemed value of the pension accrual is added to the income figure to test for ‘adjusted income’. If that combined figure exceeds £150,000 the AA will be tapered.
This can give rise to the cliff edge anomaly. As an example, if a doctor with 30 years’ service in the 1995/2008 Scheme receives a £10,000 pensionable pay increase this could give rise to a pension input amount (PIA), that is the deemed value of the pension increase, of around £70,000.
If that doctor’s income under the threshold test is £109,000, the full £40,000 AA is retained and tax on £30,000 excess PIA is due (£70,000 - £40,000).
If that doctor’s income is £111,000, the deemed income for the ‘adjusted income test’ is £181,000 (£111,000 plus £70,000 PIA). The AA will be tapered by £1 for every £2 excess, giving rise to a reduced AA of £24,500, meaning tax is now due on an excess of £45,500.
This, according to The British Medical Association, provides sufficient incentive for some doctors to refuse overtime shifts in an attempt to stay below £110,000 income.
What can be done?
In reality, not many pension scheme members will be in the position illustrated above as it requires a combination of a big pension increase and income close to £110,000 in the same tax year.
However, for those in this situation, keeping total income under the threshold will clearly be helpful. Conventional methods of reducing taxable income can be used, such as charitable donations made under gift aid.
It may also be possible to make an additional personal pension contribution to bring taxable income below the threshold. However, this is something of a double-edged sword as any further contributions will exacerbate the AA excess, giving rise to a further tax charge which the member will likely have to pay themselves. However, a small pension contribution, if it is sufficient to bring income down below the threshold, may be worth it.
Some deft timing will be required, any action to avoid breaching the £110,000 will usually need to be taken before the tax year has ended and often when final income figures may be unclear.
Two additional rules can ease the pain:
Carry forward of allowances
Pension members can look back three tax years preceding the current year and add to the current year’s AA any unused AA from those earlier tax years. This is very useful and in many cases will eliminate tax bills. Someone just hitting the threshold for the first time may well have been entitled to full AA for the previous three tax years and will not have used up that full entitlement.
The main saving grace is that the tax charge does not have to be paid by the pension scheme member directly. He or she can request the pension scheme should pay the tax charge. This is known as ‘scheme pays’.
It works by creating a notional debt account of the tax paid to which interest is added, currently at 2.4% above CPI. At retirement, a factor is used to convert the debt into a pension reduction.
Scheme pays will often be an attractive option; primarily to avoid having to find the money immediately, and for most that is enough. If the member unfortunately dies before retirement or early thereafter, the tax charge may never be repaid. It can also assist those breaching the Lifetime Allowance by reducing the value of the pension for that test.
The principle of scheme pays is relatively simple but unfortunately, the detail of the tax payment timings is not so. Applications for 2017/18 scheme pays must be made to the NHS scheme by 31 July 2019. However, there may be some elements of the tax that are technically due by 31 January 2019 for the 2017/18 tax year. Further details are found on the NHS pensions site.
Don’t check out
One action that is unlikely to be in anyone’s interests is to leave the pension scheme altogether. This leads not only to a loss of future pension benefits but also to a loss of associated employment benefits.
Tax treatment depends on individual circumstances and may be subject to change in future. The value of all investments can go up as well as down. Opinions, interpretations and conclusions expressed in this article represent our judgment as of this date and are subject to change.
Furthermore, the content is not intended to be relied upon as a forecast, research, investment advice or tax advice, and is not a recommendation, offer or a solicitation to buy or sell any securities or to adopt any investment strategy.
This article is issued by Thomas Miller Wealth Management Limited which is authorised and regulated by the Financial Conduct Authority (Financial Services Register Number 594155). It is a company registered in England, number 08284862.
About Simon Nicol
Simon joined Thomas Miller Investment in September 2016 from Broadstone Corporate Benefits Ltd where he worked for 11 years, latterly as Pension Director for the Executive Services team.
Simon has over 30 years’ experience in the pension industry and can draw on a wealth of experience and knowledge. He advises private clients as well as corporate bodies on all aspects of pensions planning particularly in recent times on the tax implications to senior executives of the latest pension legislation.
He has also taken a particular interest in the planning possibilities with pensions for those approaching retirement under the recent ‘pension freedom’ rules.
Simon frequently comments on industry matters in the press as well as providing technical papers and presentations for clients and other financial service professionals.