|Pension rules can be complicated and change frequently. It is all too easy to make mistakes and trigger large tax bills, especially for high earners and business owners. The examples here illustrate just how damaging this can be:
The following are examples only and no real client information is used.
Exceeding the Annual Allowance
On learning about the annual allowance and carry-forward, company director Ed decides to make an employer contribution of £160,000 to a pension he set up earlier in the year. This includes his annual allowance for this tax year (£40,000) plus three years’ contributions carried forward.
But as Ed only started his pension this year, he is not eligible for carry forward (had he had an old pension to use instead, this might have been possible). The pension provider can’t refund the contributions, so Ed finds himself paying his full marginal rate of tax on £120,000 of his contribution.
The money is now locked in his pension fund until he reaches age 55, at which point he will need to pay tax on it a second time if he wants to take benefits.
Had Ed consulted a financial planner:
- His contributions would have been calculated to maximise tax relief and avoid penalties
- He would have been advised to set up a pension much earlier
Exceeding the Lifetime Allowance
Simon has a deferred final salary pension and makes the maximum contributions to his current workplace pension.
- At retirement, he has a £75,000 p.a. scheme pension as well as £400,000 in his pension pot. The Lifetime Allowance is currently £1,073,100, and Simon’s benefits are notionally valued at £1.9 million (£75,000 x 20, plus £400,000). This means £826,900 will be taxed at 55% (£454,795 tax) if taken as a lump sum, or 25% (£206,725 immediate tax) plus income tax when money is drawn from his pension) if taken as income.
If Simon had taken advice:
- He could have stopped his pension contributions and invested elsewhere
- He could have applied for protection from HMRC, preserving his Lifetime Allowance at a higher level and reducing the tax
- His pension benefits could have been planned to reduce the Lifetime Allowance charge, for example by taking benefits earlier or exchanging some income for tax-free cash.
Triggering the Money Purchase Annual Allowance (MPAA)
- Julia has a workplace pension, which receives contributions of £12,000 per year (10% of her salary). She has ten years left until retirement.
She also has a small pension worth £30,000. She decides to encash this and pay the extra tax, as the amount left over will be enough to clear her mortgage.
She doesn’t realise that her pension contributions will now be restricted to £4,000 per year, otherwise tax penalties will apply. She won’t have the option to carry forward contributions from earlier years.
Julia reduces her pension contributions, missing out on ten years of full higher rate tax relief.
A financial planner would have:
- Created a plan to allow Julia to have the retirement she wanted, pay less tax and clear debt efficiently
- Encouraged Julia to think about whether she really needed to clear her mortgage now
- Looked at other ways of funding this, including taking tax-free cash only from her pension (which does not trigger the MPAA).
Please do not hesitate to contact a member of the team to find out more about retirement planning and how we can help you.