With all of us living longer, healthier lives, it’s more important than ever to ensure we have a generous pension pot when we retire. If you’re lucky enough to be enrolled in a final salary pension scheme, most of your retirement planning is done for you. A third party — usually a board of trustees — is responsible for the day-to-day management of your pension, overseeing your investments, paying your annual contributions and ensuring you receive the appropriate benefits when you retire. In recent years, the rules governing tax relief on pensions have changed, leaving some high earners with an unexpected tax bill.In this article, we take a closer look at the new regulations and what they mean for your final salary pension.What Is the Pension Annual Allowance Charge? In the UK, each of us gets a £40,000 annual allowance on our pension contributions. That means we can pay £40,000 into our pension pot each year tax free. However, for higher earners the rules are slightly different. In April 2016, the government introduced something called the tapered allowance, which placed new restrictions on pension tax relief for individuals earning more than £110,000 a year. In effect, it meant that once your income plus your pension contributions exceeded £150,000 (known as your adjusted income), your tax-free allowance began to shrink. For every £2 you earned over and above the threshold, £1 was deducted from your annual allowance, up to a maximum of £30,000. Unsurprisingly, the new measures were widely unpopular, particularly as the so-called ‘taper tax’ saw top NHS doctors hit with large tax bills. To remedy the situation, the government introduced new legislation in April this year, increasing the tapered allowance thresholds from £110,000 to £200,000 for income and £150,000 to £240,000 for adjusted income. But it’s not good news for everyone. Because while the thresholds have been raised, the minimum tapered annual allowance has been slashed. That means individuals with an adjusted income of more than £240,000 could see their annual allowance cut by more than half, from £10,000 to just £4,000.How Does the Pension Annual Allowance Affect My Final Salary Pension Scheme?Some of those hardest hit by the new legislation have been high earners with a final salary pension (otherwise known as a defined benefit pension). Unlike a defined contribution pension, where you build up a nest egg over time, a final salary pension provides a guaranteed income after you retire based on a proportion of your wages. While final salary pensions have a number of obvious benefits, one significant drawback is the lack of transparency. Typically, final salary schemes are run by a board of trustees on behalf of your employer; they decide how to invest your capital and how much to pay into your pension pot each year. Unfortunately, some schemes have fallen foul of the new tapered allowance, leaving their members with an unexpected tax bill. To prevent this from happening to you, there are a number of things you can do:
Switch to ‘scheme pays’ – ‘Scheme pays’ is a process that allows you to pay your annual allowance charge from your pension arrangement. This means your pension provider pays any tax liability on your behalf straight from your pension savings. While this might seem like the best, most sensible option, it can quickly eat into your pension fund, so think carefully before making the switch.
Transfer your pension – This may sound like a drastic option, but more and more people are exchanging their defined benefits pension rights for a cash equivalent. As well as giving you greater oversight, you’ll also have more choice as to how and when you draw your pension. However, this is not a decision to be taken lightly, so make sure you do your homework.
‘Carry forward’ – If you’ve already been hit with a large tax bill, you may be able to claw at least some of it back using the ‘carry forward’ process. This allows you to offset any charges by drawing on unused personal allowances from the previous three tax years.
Speak to a professional – By far the most sensible thing you can do is seek some advice. Pension planning is a complex process, and by consulting an expert, you can avoid the various pitfalls and ensure you get the most out of your money.