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It’s time to rethink pensions allowances

5 February 2020: the changes to tax rules governing pensions have caused huge problems in the NHS, with senior medics cutting back their hours and even retiring to avoid heavy tax bills. The complexity of the current system is hitting high earners hard, so what’s the solution?

The tax rules governing the UK’s pension system changed in 2015 with the introduction of pension freedoms, and the following year, new restrictions for higher earners came into place.

The unintended consequences of the changes became clear recently when senior medics cut back on their hours, with some even retiring, to avoid heavy tax bills.

Individuals paying into a pension get tax relief on their contributions up to an annual allowance – up to 100% of their earnings or £40,000, whichever is lower. Since 2016, this allowance has been tapered for those earning more than £150,000, with some being hit by an allowance of just £10,000.

There is no tax relief on contributions over the annual allowance, and a charge is added to taxable income when it is exceeded.

The drastically reduced limit means that, in some cases, workers can face a tax bill that wipes out any additional earnings altogether.

One rule for one; one rule for another

In all pension schemes where the tax liability is more than £2,000, any member can ask the scheme to pay the tax charge. This normally creates a debt that is repaid at retirement from the member’s pension pot.

In November 2019, the NHS committed to making up the difference when staff retired to ensure they would be no worse off. However, a sticking plaster solution for one scheme does not solve the underlying problem.

It is understood that the NHS is only paying the annual allowance charge for 2019/20 pending agreement of a solution to the problem going forward.

In simple terms, an NHS "consultant" earning £150,000 per annum with a final salary NHS pension that increases by £3,158 after an inflation adjustment during 2019/20 is deemed to have paid pension contributions equivalent to 19 times this amount: ie, £60,000. This is a complex calculation as the normal "16 times" rules for people in government pension schemes is not used (these figures are for illustrative purposes).

£60,000 is then added to their other income. Assuming this is limited to their salary, total income for pension tapering purposes is £210,000 and they are therefore fully tapered and have a reduced annual allowance of £10,000. Assuming they have no relief brought forward they will have to add £50,000 to their income and pay tax at 45% on this "notional" income, ie, £22,500.

This can be paid by the scheme, in which case a debit of £22,500 is added to their pension account and when they retire the sum of these debits plus interest is commuted into a notional pension debit which is deducted from their pension. These debits are not that generous relative to the amount needed to buy a replacement annuity on the open market. The alternative is to pay £22,500 from their gross income of £150,000 after tax which is a large amount in relative terms.

Understandably NHS consultants are aggrieved and this has been brought to the public’s attention because they are limiting their overtime to reduce their income and the tax charge, which is not in the public interest.

Consultants are not the only group in the workforce affected by the rules though, as many high earners in final salary schemes are in the same position. However, many of the affected professions are less likely to be of public interest.

The scenario, therefore, begs the question as to how the government will handle this problem. The rule has backfired on them in the case of NHS consultants, and experts suspect they may introduce concessions as they did for judges - but we will have to wait and see.