We’ve known about the problems for high earners losing their pension lifetime allowance protection for some time. They now have an exemption from auto-enrolment if their employer knows that enrolment would jeopardise their tax privileges in retirement.
But now there’s another threat; the threat of 100% taxation on contributions under auto-enrolment when someone’s hit their annual allowance from next tax year. This may sound fanciful but there is a big problem brewing.
Provided you earn under £110,000, you have an annual allowance to pay into pensions of £40,000 pa. But that allowance tapers to £10,000 on your earnings over £110,000 at a rate of 50p for every £1 you earn over £110.000 -with everyone earning over £210,000 only having an annual allowance of £10,000.
If that isn’t hard enough, the definition of earnings is different depending on how much you earn. If you earn below £110,000 your income for these purposes is pretty well your earnings for national insurance providing you don’t have any income from other purposes.
But if your “outside earnings” tip you over the £110,000 “total earnings threshold”, things get really tricky. Firstly you are losing your annual allowance on a tapered basis (see above) but secondly, your total income including pension contributions could tip you over another pension threshold at £150,000
If your total taxable income including pension contributions exceeds £150,000, your pension contributions also become taxable meaning that your annual allowance for pensions is reduced as if the pension contributions which have tipped you into the new bracket were income.
What all this means is that many people may start out a tax-year expecting to contribute £40,000, but find that they are breaching their annual allowance a lot sooner than they thought. As soon as they do so, they can find – under the very punitive rules that apply to those breaching the allowance – that they could be taxed at a marginal rate of 67.5%.
If people invest additional contributions into a pension once they have breached the annual allowance, the end to end outcome can an income tax-rate close to 100%. This would occur if they pay tax when they exercise their pension freedoms. If we were to include an extra tax charge if the lifetime allowance has been breached, the situation becomes even more serious though I suspect that HMRC might baulk at demanding tax for a benefit that had already been reduced to nothing by 100% taxation.
There are thee practical issues for employers
Firstly, how they communicate to vulnerable employers. It’s easy enough to assess who is under what threshold if all that is being considered is NI-able income. But what about that outside income and how can an employer keep tabs on that (even if the employee has kept tabs!). In practice most employees won’t know (for sure) about their breach for sure till they do their self-assessment the following year!
Secondly ,how employers protect members from paying unnecessary tax. Employers can put in a cap on all pension contributions at £10,000 and pay salary in lieu but that’s expensive in terms of income tax and national insurance and would doubtless penalise some who would have been better off with higher pension contributions.
Thirdly, how auto-enrolment operates. Even if an employer is taken out of the pension (for contribution purposes), he or she will become an eligible jobholder and will be auto-enrolled back in. Those auto-enrolment contributions could attract an income tax charge at self assessment of 67.5% plus more to come at retirement if freedoms aren’t exercised with care and LTA is breached.
And this can’t be sorted by salary sacrifice as all new salary sacrifice arrangements will be considered artificial (new being post July 2015). The salary (or bonus) sacrificed will be considered part of the annual allowance or (if below the £150k threshold) part of adjusted earnings.
The only good news for high earners is the Pension Input Period alignment (and mini-PIP rules) which may give them some flexibility, but this is one for another article!
We may see payroll software re-coded to take this into account but all of this is transitional. I doubt there will be much appetite to re-code with so much further change in the pipeline. This means a lot of manual messing around and a lot of individual conversations with senior staff.
We had hoped that the agony of the current consultation on pension taxation would be over on November 25th and the Autumn Statement. But we were wrong! The Autumn Statement will now announce a green paper which will allow the Treasury four more months to sort this mess out!
In the meantime, we have written to the Pension Regulator asking that we can at least have an exemption from auto-enrolment for high-earners opting out of pension contributions to avoid the punishment of the annual allowance.