For most doctors and dentists, annual allowance is one of the greatest areas of interest and concern when it comes to their financial and tax planning. Annual allowance is the ultimate ‘stealth tax’ in the medical profession and seems to creep up and catch many unawares.
If you would like a refresher on the annual allowance, we have done a brief summary at the end of this article. If you know your annual allowance then read on…
After assessing your annual allowance situation and taking into account Carry Forward you have an annual allowance pension tax liability. What are your payment options?
You have 3 options for paying an annual allowance tax liability, all of which have some limitations.
First option
You can use your own capital to pay the tax liability, typically savings. The downside to this option is that you may not have the available savings, or any capital you do have may be earmarked for something else. Usually, savings are accumulated from disposable income. The income generated from these savings is of course taxable, and income tax and national insurance have probably already been paid. Your capital may have come from some inheritance, where inheritance tax may have already been paid. So, using already taxed savings to pay an additional tax liability seems like double taxation.
Second option
NHS Pension Scheme Pays – The NHS pension scheme will allow you to pay the liability from the NHS pension scheme. This option is available within certain time limits (covered below). In return for paying the annual allowance tax liability the NHS pension scheme will make a permanent reduction to your NHS pension benefits.
With the NHS Pension Scheme Pays option, you instruct the NHS pensions agency to pay the annual allowance tax liability via an application. The NHS pensions agency will assess your application, and as long as you are within the rules, they will make a payment to HMRC. The value of that payment then becomes a debt against your NHS pension benefits.
If you are a member of two NHS pension schemes (for example; the 1995 section and the 2015 section), you will need to instruct the NHS pensions agency how much of any liability relates to each scheme. It is not possible to ask one of the schemes to pay the whole amount if it has come as a result of input growth from both.
Let me explain…Firstly, the technical bit. The debt against your pension is called a Notional Negative DC account.
The amount of annual allowance charge that the NHS pensions agency pays to HMRC is recorded as a separate account on your pension record, known as a Notional Negative DC account.
In basic terms, the NHS pensions agency is loaning you the money now to pay your annual allowance charge across to HMRC, which you must then pay back to the NHS pensions agency, with interest, when you retire, or if you transfer out.
Interest on the Notional Negative DC account
Interest is added to the account annually based on the:
- Previous Septembers’ CPI figure; plus
- Superannuation Contributions Adjusted for Past Experience (SCAPE) discount rate.
Therefore, if you decide to use the NHS Scheme Pays, to pay an annual allowance tax liability for 2020/2021 tax-year (for example purposes £10,000) the NHS would pay £10,000 to HMRC. Your annual allowance tax liability has now been met as far as HMRC are concerned.
The NHS pensions agency would create a Notional Negative DC account to run alongside your NHS pension.
Let us assume you are age 55 and intend to take your NHS pension benefits in full at age 60. CPI for September 2021 is 3.1%, and the SCAPE discount rate is 2.4%. Total interest rate 5.5%. By the time you reach the age of 60, the debt against your pension will have increased with interest to £13,070. If this debt had been running for 10 years to age 65 in this example, it would have increased to £17,081.
How do the NHS pensions agency recover the debt?
As mentioned above, the NHS pensions agency will make a permanent reduction to your pension (and lump sum in the 95 section) to recover the debt once you decide to take your NHS pension benefits.
The amount your retirement benefits will be reduced differs slightly between the various NHS pension schemes. We can complete a personalised report detailing individual circumstances if required as part of a financial/NHS pension scheme review.
Using the example above of an initial annual allowance tax liability of £10,000 for a 55-year-old doctor who wishes to retire at 60, the reduction in pension based on current reduction tables would see a depletion in their NHS pension of £628 p.a. and a reduction in a lump sum of £691. (assuming that £4,000 of the total £10,000 liability covers the 95 section and £6,000 covers the 2015 section).
N.B. The NHS scheme actuarial reduction tables are indicative and could change in the future.
What effect will the reduction have on future income tax liabilities?
It is also worth noting that the reduction comes off the total NHS pension benefit entitlement. Many senior doctors with significant time membership within the NHS pension scheme will have built pension entitlement above the higher rate income tax (HRT) threshold (c. £50,271). They may also decide to exercise, retire and return where a combination of earned income and pension income results in high-income levels well above the HRT threshold. Doctors may continue with private practice, take income held in a limited company or take on legal work after drawing their NHS pension benefits. All of which produce income potentially subject to income tax.
In the above example. If the doctors NHS pension entitlement is for a pension of £55,000 then the net reduction of £628 p.a. would result in an after-tax reduction of £376.80 p.a.
If inflation is 2.5% p.a. It will take the member 22 years to cover the original £10,000 annual allowance tax liability (£10,000 – £691 lump sum reduction = £9,309. 22 x 376.80 x 2.5% p.a.).
The time it takes to repay the £10,000 for a basic rate taxpayer will be less as the net pension reduction would be £502.40.
Please remember the reduction in NHS pension benefits using NHS Pension Scheme Pays is permanent. Therefore, if you live longer than the time it takes to cover the original payment you will pay more.
Is there any interaction with the pensions Lifetime Allowance if the NHS Scheme Pays is used?
So far, we have only discussed pensions’ annual allowance. There is, however, another form of pension taxation, pensions Lifetime Allowance (LTA).
As a quick reminder, if the value of your total pension benefits and any previously crystallised pension benefits (the term crystallisation refers to the point in time you take any pension benefits, and the value of those benefits when measured against your pensions lifetime allowance) are greater than the standard LTA or your protected LTA if higher the excess is taxed at a rate of 55%, if the excess is taken as a lump sum or 25% if the excess benefits are taken as income. As the NHSPS will pay your benefits mainly as income with any lump sums taken as a result of computation of income, or built alongside the pension income benefits in the case of the 95 section, they will usually tax any excess benefits over the Lifetime Allowance at a rate of 25%.
The NHS pensions agency will make a payment directly to HMRC and then reduce your NHS pension income by a factor determined by the NHS pension actuary tables.
How is this affected by using NHS Pension Scheme Pays?
If we continue to use the example above, the doctor has an entitlement to a standard NHS pension of £55,000 and a standard lump sum entitlement of £165,000. If the doctor has not used the NHS Pension Scheme Pays to meet the £10,000 annual allowance tax liability the value of their NHS pension benefits when measured against the standard Lifetime Allowance is £1,265,000 (pension x 20 plus lump sum). The standard Lifetime Allowance is currently £1,073,000 and has been frozen at this level for the foreseeable future. The value of the NHS pension benefits above the Lifetime Allowance is therefore £192,000. The Lifetime Allowance recovery charge (LTA tax payable) will be 25% of the excess, consequently, a tax liability of £48,000.
This tax liability will be paid by the NHS pension scheme direct to HMRC. The NHS pension scheme will then reduce the members’ pension by £2,216 p.a. The lump sum will not be reduced. (This is based on current NHS pension scheme actuarial tables and assumes benefits are from the 95 section only).
- NHSPS income after Lifetime Allowance reduction (assuming annual allowance liability paid from members own savings) – £52,784
- Lump sum £165,000
Now let’s look at what happens to the Lifetime Allowance liability if the member uses NHS Pensions Scheme Pays.
Any reduction to the members NHS pension entitlement comes off the pension before a valuation for Lifetime Allowance is completed. Therefore, the value of the members’ NHS pension benefits net of annual allowance deductions is £54,372, and the lump sum is £164,309.
The value of these benefits, when measured against the Lifetime Allowance, will be £1,251,749 (pension x 20 plus lump sum). Therefore, the excess over the standard (non-protected LTA) is £178,749. Lifetime Allowance recovery charge is 25% of the excess = £44,687. As opposed to £48,000, if NHS pension scheme pays were not used. A difference of £3,313. This sum, again, will be paid by the NHS pension scheme direct to HMRC, and the NHS pension scheme will then reduce the members’ pension by £2,063 p.a., the lump sum will not be reduced. (This is based on current NHS pension scheme actuarial tables and assumes benefits are from the 95 section only).
So, what effect will the combination of annual allowance and lifetime allowance reduction have on the members’ pension benefits?
- NHSPS income after Lifetime Allowance reduction (assuming annual allowance liability paid using NHS pension scheme pays) – £52,309
- Lump sum £164,309.
The interaction between pensions annual allowance and pensions lifetime allowance, if NHS Pension Scheme Pays is used in the above example results in an actual decrease in the members NHS pension benefits of £475 p.a. and a reduction in the lump sum of £691.
However, as the pension income benefits would be taxed at the higher rate tax level the net reduction in pension would be £285 p.a.
Now for the long awaited…
Third option
The third route if applicable could well prove the most appealing.
HMRC allows an annual allowance tax liability to be paid by any UK registered pension scheme. Some doctors will hold “defined contribution/money purchase” type pension schemes in the form of personal pensions, SIPP’s and AVC/FSAVC’s. In some cases, these will have significant holdings, therefore, you can ask your personal pension/SIPP/AVC provider to pay the tax liability from your personal pension account.
Why is this option appealing?
- PP/SIPP/AVC accounts will have had very little tax paid on the funds held, and you would have received tax relief on the contributions. Therefore, these accounts will not have been accumulated from already-taxed income.
- The decision you take on which of your pension benefits (NHSPS or Defined Contribution) you crystallise first will very much depend on your individual circumstances both at and possibly prior to retirement. It is worth bearing in mind for many of our senior doctors, if the NHSPS benefits are taken first, the NHS pension will potentially use all or the majority of the available lifetime allowance. This will mean that any PP/SIPP/AVC pension benefits could be subject to the full force of any Lifetime Allowance recovery charge – this could be as high as 55%.
Therefore, it could make sense to pay any annual allowance liability from Defined Contribution arrangements if as a result of retirement planning you decide the NHS pension scheme will be the initial crystallisation event.
- NHS pension benefits are indexed linked in retirement. The compounding effect of index linking is greater, the higher the starting amount. Paying annual allowance tax liabilities from money purchase arrangements will limit these reductions.
However, there is a major drawback to using your defined contribution/money purchase arrangements to pay annual allowance liabilities. While it is theoretically possible to use these accounts to pay annual allowance tax liabilities, very few providers will actually offer this facility. These pension accounts can be quite old, and the providers simply do not have the systems to allow payments of this nature.
Also, it is not necessarily in the provider’s interest to allow this. They, therefore, do not offer the ability to pay an annual allowance liability that has arisen from pension growth in another scheme such as the NHS pension scheme.
Another potential solution
We know of two providers offering an annual allowance scheme pays, facility for liabilities that have arisen from other pension schemes. Fortunately, these providers offer personal pension accounts with all the flexibility now theoretically available from pensions following the “Pension Freedoms” legislation of 2015. They also offer full ranges of fund choices available on the open market.
However, unless you already hold pension funds with these providers, you would need to transfer benefits from your existing provider (assuming they do not offer scheme pays to cover liabilities arising from another pension scheme). Transferring pensions will take some consideration, and we would always recommend you seek independent financial advice. Independent financial advice comes at a cost, which you would need to consider before transferring pension benefits, as well as other considerations.
Let’s summarise
The combination of all of these factors (net pension reduction, impact on lifetime allowance recovery charges, member capital/savings remaining available for the member rather than paying to HMRC at the time the annual allowance liability arises) makes the NHS Pension Scheme Pays, a worthwhile consideration.
However, each pension member’s individual circumstances will be different and the younger the member the greater the effect of compounding interest charges on the notional negative DC account.
Well done for sticking with us – this is a long and complex article, but hopefully, you now have sufficient information to make an informed decision. However, with a topic this important we would always ask you to consider specialist independent financial advice before any final decisions are made.
If you have an annual allowance tax liability will you be utilising scheme pays? Let us know by adding a comment below.
Appendix
Annual allowance explained
Every UK resident taxpayer has a “standard pension annual allowance” of £40,000, meaning they can contribute £40,000 into “defined contribution pension arrangements” (typically personal pension, group personal pension and money purchase occupational pension schemes). These contributions are total payments made into the pension arrangement in a single tax year from all sources, typically personal and employer contributions.
Defined benefit pensions
For defined benefit pensions such as the NHS pension schemes, what actually determines the annual allowance contributions in any given tax year is the growth within the NHS pension scheme or schemes (not the actual pension contributions). This is called your NHS pension input amount.
The NHS Business Service Authority (NHSBSA) typically sends you your annual allowance pension savings statement by October 6th each year. This statement will show your pension input amount and if you have exceeded the standard £40,000 limit.
You can request your statement from NHSBSA if you do not receive one automatically. This is particularly important if you have a reduced annual allowance.
A lower annual allowance limit may apply if you are subject to tapered annual Allowance or Money Purchase annual allowance. Tapered annual allowance was introduced in April 2016. These rules can reduce your annual allowance from £40,000 to £10,000 (£4,000 from 2020/21). This could increase your annual tax bill by as much as £13,500 (£16,200 from 2020/21). The rules for tapered annual allowance are very detailed and have been covered in separate articles.
Carry Forward
Carry Forward allows you to make use of any annual allowance that you may not have used during the three previous tax-years, provided that you were a member of a registered pension scheme. To use Carry Forward, you must first make use of all of your annual allowance in the current tax-year, then any unused annual allowances from the three previous tax-years can be utilised.