Planning opportunities around scheme pays
Gareth James, head of technical resources at AJ Bell looks at when it pays to scheme pay in the right way
The last couple of months have seen a succession of headlines confirming the growing impact of the annual allowance, in particular the tapered variety, on pension savers.
We’ve seen reports of a tripling in the amount of tax raised by HMRC from annual allowance charges between 2015/16 to 2016/17, with the tax take rising from £179m to £561m.
Members of public sector schemes are reported to be taking out loans to cover annual allowance charges, or refusing to take on additional work because the extra earnings (and so benefit accrual) would lead to significant tax charges.
Finally young doctors, a term I’m old enough to associate with Australian soap operas rather than pension taxation, have been warned about the financial impact on their retirement benefits if they pay the tax charge from their NHS scheme rather than from personal funds.
Readers will I’m sure know that this is a reference to ‘scheme pays’, the option of arranging for an annual allowance charge to be paid by the scheme administrator from the scheme under which the tax liability arose, with a corresponding reduction in the value of pension benefits as a result.
Scheme pays can result in a more tax efficient solution than paying the tax charge personally, particularly when looking at DC schemes, because the tax is being paid from tax-relieved assets, rather than from personal cash which has already been subject to tax. The option does need to be considered carefully under DB schemes because of the loss of potentially valuable lump sum and pension rights.
This last point, and a case which recently crossed my desk, has led me to wonder whether there are opportunities in planning for potential future annual allowance liabilities and whether those planning opportunities might lead to negative tax impacts that the Government has not anticipated.
The case involved a client who had not made any contributions to their SIPP but wanted to know whether we would allow the scheme pays option to be used in relation to a liability that had arisen entirely in a public sector pension scheme. Their logic – which appeared valid on the basis of my own calculations – was that settling the liability from a DC scheme would have a significantly smaller impact on their retirement income than if scheme pays was used from their final salary scheme.
The detailed calculations are beyond the scope of this article but, if you compared the future annuity that might be available from the SIPP, with the future guaranteed pension available from the public sector scheme, paying the charge from the DC scheme would ‘cost’ the client several thousand pounds per annum less in annuity income, than the income effect of paying the charge from their final salary scheme.
That’s an interesting planning point where clients are facing scheme pays tax charges right now – although it is worth mentioning that administrators can’t be forced to allow scheme pays where the tax liability didn’t arise under their own scheme. Does the client have DC benefits from which the charge can be paid, and is it beneficial in terms of impact on future income to pay the charge from the DC scheme?
It also started me wondering whether it made sense to pre-plan for annual allowance charges arising under final salary schemes. So might it make sense for members of final salary schemes who know they are likely to face these charges in the future to make contributions to DC schemes to build up a pot from which future annual allowance charges could be paid?
An example might be a doctor who is already a higher rate tax payer, but not yet affected by the tapered annual allowance, who is expecting to be affected by it in the future. Could it make sense for that doctor to make personal contributions to a DC scheme and obtain 40% tax relief, with a plan to use those funds to pay annual allowance charges once the tapered allowance hits? To work as efficiently as possible the contributions should be paid at least four years before the annual allowance charge hits to avoid using up carry forward which might later be needed.
From a Government perspective, if significant numbers of individuals started using this tactic, short term tax relief costs could increase, as members of public sector and other final salary schemes prepare for the possibility of future annual allowance charges.
The Government also needs to consider that if tax charges are paid from DC schemes rather than public sector schemes, and the Government was expecting a reduction in future liabilities from the use of scheme pays through those schemes, this activity could scupper those plans.
It will be interesting to see if this planning opportunity achieves any traction and how the Government reacts.