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Tax on pension savings: Not what the doctor ordered

One of the many tax stories to stir strong feelings in recent months is the high marginal tax rates borne by higher-paid public servants whose pension contributions exceed their annual allowance. In the case of higher-paid NHS staff, mainly consultants, some are even retiring early or going part-time because it is costing them money to work extra. This has knock-on effects in the wider NHS with delays and cancellations to surgery.

How does an abstruse piece of tax policy cause such social upheaval?

Pensions taxation: 2015 onwards

The years from 2015 to 2017 saw a lot of complex changes to the taxation of pensions. In 2015, perhaps the most radical liberalisation of pension rules in decades took place as contributors to defined contribution schemes were given the right to draw on their pension funds as they wished, without having to take an annuity on retirement.

There then followed various attempts to limit the amount of tax relief that wealthy contributors could claim. By 2016, the lifetime allowance (LTA), the maximum pension saving an individual can accumulate over their lifetime while qualifying for tax relief, had been reduced from £1.8 million in 2010/11 and 2011/12 to £1 million. Also, in that year, the annual allowance taper was introduced, an immensely complicated set of calculations that gradually reduces the amount of tax-free pension savings an individual can build up in a tax year (the annual allowance (AA)) if their annual income combined with the growth in their pension fund exceeds certain thresholds.

The annual allowance taper

A detailed exposition of the AA taper calculation can be found in the Office of Tax Simplification (OTS) report Taxation and Life Events, Chapter 3 and Annex 3, with a worked example in Annex 4.

In brief, when annual growth in the pension fund exceeds the AA, a tax charge is triggered. The taper kicks in when an individual’s threshold income exceeds £110,000, and their adjusted income exceeds £150,000. The AA, normally £40,000, is progressively reduced by £1 for every £2 by which adjusted income exceeds that £150,000 threshold, until it reaches the minimum AA of £10,000 when adjusted income is £210,000 or more.

Threshold income is, very broadly, taxable income from all sources less tax relief. Adjusted income is threshold income plus pension input amount, which, for defined contribution (DC) schemes, is the total contribution made by the individual and their employer, and any other contributions made on the individual’s behalf, during the pension input period which is the tax year. For defined benefit (DB) schemes, the pension input amount includes investment growth in the pension fund during the year, which equals the difference between the figures found by taking the opening and closing values (i.e. the valuation at either end of the tax year), multiplying each by 16, adding any lump sum and increasing by CPI inflation.

The combined effect of imposing a tax charge on exceeding the AA, while at the same time reducing the AA in-year, can produce some exceptionally high marginal rates of tax. One of the examples in the OTS report features a consultant whose £5,046 payrise triggers an AA charge of £10,475! Because people generally do not know by how much their pension fund has grown until after the year end, the tax charge often creeps up on them unawares; for example, a hospital consultant is not to know that by working an extra shift, say, they have attracted an employer contribution to their pension fund which breaches the AA and triggers a tax charge.

There is a Micawberish inevitability about the calculation – threshold income £109,900: result happiness; threshold income £110,100 and adjusted income £150,100: result misery. Particularly in the case of DB schemes, the individual has little or no control over the growth in their pension fund and in cases such as the NHS pension scheme, which is fairly rigid in its rules, any additional amount earned entails a pension contribution which will inevitably increase the fund’s growth. Because the AA taper is triggered as soon as the income thresholds are exceeded, the charge is impossible to predict.

The route which many health professionals in those earnings brackets have taken is to cut their hours or retire early, depriving the NHS of skills and experience it can ill afford to lose. A parliamentary debate[1] offers numerous examples of this. Alternatively, they avail themselves of a mechanism known as ‘scheme pays’, under which the pension fund pays the tax charge. However, the payment is treated as a loan to the contributor, which has to be repaid out of the pension fund when they retire. Over the years, that can amount to a considerable depletion of their fund.

For every ill a remedy?

According to the OTS report, the AA charge affected 18,500 individuals in 2016/17.

The OTS report recommends that: ‘the government should continue to review the annual allowance and lifetime allowances and how, in combination, they deliver against their policy objectives, taking account of the distortions (such as those affecting the National Health Service) they sometimes produce.’

It suggests that one solution may be to restrict pension tax relief for DB schemes by reference to the lifetime allowance rather than the annual allowance, vice versa for DC schemes. The report also calls for HMRC to correct what seems to the OTS to be vagueness and ambiguity in parts of the official guidance on the tax consequences of particular pension arrangements.

Naturally, the government is concerned about the huge amount of money spent on income tax and NIC relief on pension contributions - £36.7 billion in 2016/17 – and has so far inclined to the view that the solution lies in making the NHS pension scheme more flexible. On 7 August 2019, therefore, a consultation proposed that senior clinicians should have full flexibility over how much they put into their pension pots, and their employers should be able to recycle any unused contribution back into the clinician’s salary. At the same time, the Treasury will review how the tapered annual allowance supports the delivery of public services such as the NHS.

Clearly, there will have to be more than just a review, and in any case we shall hear no more about it from the government until after the current general election purdah. But whichever government is returned in December, solving this tax riddle will have to be high on their agenda if the NHS is not to suffer long-term damage.

Robin Williamson MBE CTA (Fellow) is an author and commentator on tax, welfare and public policy. He was previously technical director of the CIOT’s Low Incomes Tax Reform Group (2003-2018), and a senior policy adviser at the Office of Tax Simplification (2018-2019).

[1] ‘NHS pension scheme: tapered annual allowance’ (2 April 2019, volume 657)

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