Taxation of pensions
01 April 2020
Helen Hargreaves MSc ChFCIPPdip, CIPP associate director of policy, provides a comprehensive explanation.
We all know that when the government wants the public to do something, it will often use tax breaks to encourage us to comply, with perhaps the most widespread being the pension tax relief that is afforded to those using a pension to save for retirement. But is it really so straight forward, and do we all really benefit?
Workplace pensions
The government tells us that when we make a contribution to our pension, it will add money too in the form of tax relief and is one of the main advantages of using a pension to save for retirement. But whilst this is true, it doesn’t tell the whole story, as there are different ways of attracting pensions tax relief, and it may be that not everyone gets the tax relief they might have expected.
Employers operate one of two pension scheme types in relation to auto-enrolment. One of those schemes is the net pay arrangement (NPA) for pension contributions. This involves deducting an employee’s pension contribution from their gross pay, prior to tax deductions – the theory behind this being that it reduces the amount of tax an individual pays. The other is the relief at source (RAS) arrangement. In a scheme of this nature, pension deductions are taken from the employee’s net pay – after tax deductions – which forms 80% of the contribution. The remaining 20% is claimed back by the pension scheme as tax relief from HM Revenue and Customs (HMRC) and added to the individual’s pension pot. The rationale is that both types of arrangement offer tax relief for employees on their pension contributions but unfortunately this is not the case for every single pension contributor.
When an employer chooses a pension provider, the pension scheme they choose may work well for some of its employees but not for others.
The auto-enrolment threshold is for earnings above £10,000 but the current basic tax threshold is £12,500. Anybody who is earning between £10,000 and £12,500 and in a NPA pension scheme will have a full pension deduction taken from their pay but will not receive any tax benefit on this contribution as they have not earned enough to attract tax on their earnings. If they were in a RAS arrangement, they would only have 80% of the contribution taken from their net pay which would then be topped up with 20% from HMRC and they would therefore enjoy the benefit of tax relief. It becomes apparent that something as simple as the way in which relief is claimed/obtained can have a massive impact on the pension savings of employees up and down the country.
Employees who do not earn £10,000 or above to meet the threshold for auto-enrolment but ask to be added into a pension will also be affected. This is also true for individuals who don’t reach the threshold, but in some pay periods experience a pay spike, e.g. they receive a bonus. If this pay spike pushes them into the £10,000 earnings bracket for that pay period and there are further spikes in subsequent pay periods, then contributions will be taken in line with auto-enrolment legislation but, again, there will be no tax benefit to the employee if they have not have earned enough for tax deductions to be taken.
Conversely, in a RAS arrangement, employees who are earning within the higher and additional tax brackets only receive a 20% top up to their pension pots from HMRC through payroll, as opposed to the 40% and 45% they are entitled to (21%, 41% or 46% in Scotland). In order to receive the extra relief due to them, these individuals need to complete a self-assessment tax return. Many of those affected by this may not be aware of the processes they need to follow to receive the relief or may not be aware of the additional entitlement at all. Although, in an unusual twist, Scottish taxpayers on the starter rate of 19% also receive the 20% top up.
Net Pay Action Group
There are an estimated 1.3 million workers (75% of whom are female) earning below or just above the personal income tax allowance not receiving tax relief on some or all their contributions because their employer’s pension scheme uses NPA; this makes pension saving up to 25% more expensive for them as compared to a worker contributing to a RAS arrangement.
The CIPP is a member of a group campaigning to ensure that there is a level playing field for all pension contributors, and strongly believes that the government should address these issues. We will keep you updated as the campaign progresses.
There’s always a limit
Employees can pay as much as they like into their pensions, but there are annual and lifetime limits on how much tax relief is available on pension contributions.
In the tax year 2019/20 tax relief was available on pension contributions of up to 100% of earnings or a £40,000 annual allowance, whichever was lower – the limits for 2020/21 had not been published at the time of writing this article.
Any contributions made over this limit do not attract tax relief and are subject to income tax along with the employee’s other income. However, unused allowances can be carried forward from the previous three years, as long as the individual was a member of a pension scheme during those years. Another point to note is that since April 2016 the annual allowance is reduced for individuals with an income of over £150,000, including pension contributions. For every £2 over £150,000 the annual allowance falls by £1, subject to a minimum annual allowance of £10,000.
The MPAA
As with most things in life, there is an exception.
Individuals taking money from a defined contribution pension can trigger a lower annual allowance known as the money purchase annual allowance (MPAA). For the tax year 2019/20 the MPAA was £4,000. Unused MPAA cannot be carried over to another tax year.
Whether the MPAA applies depends on how the pension pot is accessed; and as you might expect, the rules are complicated. The main circumstances for triggering the MPAA are:
- taking an entire pension pot as a lump sum or starting to take ad hoc lump sums from the pension pot
- putting the pension pot money into a flexible income product (also known as pension drawdown) and starting to take income
- buying an investment-linked or flexible annuity where the income could go down
- taking payments that exceed the cap from a pre-April 2015 capped drawdown plan.
The MPAA will not usually be triggered by:
- taking a tax-free cash lump sum and buying a lifetime annuity that provides a guaranteed income for life that either stays level or increases
- taking a tax-free cash lump sum and putting the pension pot into a flexible income product (also known as pension drawdown) but not taking any income from it
- cash in small pension pots valued at less than £10,000.
Lifetime allowance
There is also a lifetime allowance, which in 2019/20 was £1,055,000. Any amount in the pension pot above the lifetime allowance is subject to a tax charge, which is a one-off charge of 25% if paid as pension or 55% if paid as a lump sum. The charge can be applied in either of the two ways or a combination of both depending on how the benefits exceeding the lifetime allowance are taken. Individuals with large pension pots need to monitor their savings closely to ensure they do not exceed this limit.
The introduction of auto-enrolment caused problems for many individuals who had already accrued pension savings above the lifetime allowance when it was reduced in April 2016. However, these individuals can apply to protect their pension savings from tax charges, provided no further tax-relieved pension contributions are made.
Where an employer has reasonable grounds to believe that the member of staff has this protection, then the employer can choose whether or not to put them into a pension scheme or to re-enrol that member of staff.
Refunds to scheme
An employee may be able to get a pension scheme refund if:
- they have been automatically enrolled into a workplace pension scheme and have opted out within a month of their first contributions being taken
- they have less than thirty days of service when they leave employment.
How are pension refunds processed?
Pension refunds can be processed in two different ways:
- directly via payroll if contributions have not yet been invested to the pension scheme administrator, or
- directly from the pension scheme administrator. It is an employer’s responsibility to provide the scheme administrator information to an employee if a refund needs to be processed directly from the scheme.
Contribution refunds
If members ask to leave a pension scheme, the rules may allow them to take a refund of their contributions, but this also has tax implications, depending on how the contributions were made.
Contributions refunded from a defined benefit or money purchase pension scheme are taxed at 20% on the first £20,000 and at 50% on the remainder.
The amount an individual will receive back from a personal pension or stakeholder pension scheme is the contributions that have been paid, net of basic rate income tax relief.
In a NPA scheme where the contribution is taken before tax, the contributions have reduced the taxable pay. Therefore, a pension refund should increase taxable pay ensuring that tax is paid on the pension refund.
Tax calculations must be based on the gross pay including the pension refund which will reverse the tax treatment received when the contribution was deducted initially.
Any refund of RAS contributions can be added to the employee’s net pay as they did not attract any tax relief when they were initially deducted so the amount deducted from the employee was a net amount.
This article was featured in the April issue of Professional in Payroll, Pensions and Reward magazine and was correct at the time of publication.