For many doctors and dentists, the annual allowance is a key focus and a significant concern in their financial and tax planning. Often referred to as the ultimate ‘stealth tax’ within the medical profession, it tends to catch many off guard, even in the wake of the McCloud remedy fallout and the subsequent issuance of revised annual allowance statements. After evaluating your annual allowance position and considering Carry Forward, you discover you have an annual allowance pension tax liability. What are your options for payment?
We have a brief summary at the end of this article for a quick refresher on annual allowance. If you know your annual allowance then read on…
You have 3 options for paying an annual allowance tax liability, all of which have some limitations. Let’s go through the options one by one…
Option One
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, plus the loss of interest or growth this capital now won’t attract needs to be considered.
Option Two
NHS Pension Scheme Pays – The NHS pension scheme allows you to pay the liability from the NHS pension scheme. This option is subject to specific time limits, outlined below. In exchange for covering this tax liability, your NHS pension benefits will be permanently reduced.
By choosing the 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 review 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 allocate the entire liability to one scheme if it results from input growth across multiple schemes.
Let me explain…Firstly, the technical bit. The debt against your pension is called a Notional Negative Defined Contributions (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 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 added on the Notional Negative DC account
Interest is added to the account annually based on the:
- Previous September’s Consumer Price Index (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 the 2023/2024 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 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 2024 is 1.7%, and the SCAPE discount rate is 1.7%. Total interest rate 3.4%. By the time you reach the age of 60, the debt against your pension will have increased with compound interest to £11,879. If this debt had been running for 10 years to age 65 in this example, it would have increased to £13,970. Please note that the Consumer Price Index (CPI) fluctuates, directly impacting the interest rate applied. For example, in 2022/23, the CPI was 6.7%, resulting in a total interest rate of 8.4%!”
Consumer price inflation tables – Office for National Statistics
How does the NHS pensions agency recover the debt?
As previously mentioned, the NHS pensions agency will apply a permanent reduction to your pension and your lump sum if you are in the 1995 section to recover the debt when you choose to take your NHS pension benefits.
The reduction in your retirement benefits varies slightly across the different NHS pension schemes. As part of a financial or NHS pension scheme review, we can provide a personalised report tailored to your specific circumstances. If you would find this helpful in deciding which payment route to take, please don’t hesitate to get in touch.
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. gross, which is liable for income tax and a reduction in a lump sum of £691, which is likely to be tax-free. (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.
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 or partial retirement, both of which would result in a combination of earned income and pension income giving high-income levels well above the Higher Rate Income Tax 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 doctor’s 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, assuming they are a higher rate income taxpayer.
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.
Are there any other taxes to think about here?
Historically we needed to contemplate the Lifetime Allowance (LTA) when discussing Scheme Pays as it reduced the deemed value of the NHS pension, which was useful as the overall ‘value’ of the pension could give rise to additional taxation above certain limits. Happily, the LTA was abolished on 6th April 2024.
Option Three
The third route if applicable could 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 and AVC/FSAVCs. 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 will have received tax relief on the contributions. Therefore, these accounts will not have been accumulated from already-taxed income.
- The choice of which pension benefits to crystallise first—NHS pension scheme (NHSPS) or defined contribution will largely depend on your unique circumstances, both at retirement and potentially earlier. It is worth bearing in mind for many of our senior doctors, that if your retirement expenditure can be covered for the most part by your NHS pension your personal pension, FSAVC etc won’t be drawn and is earmarked to be handed onto your family on your death. In the past, this was possible tax-free if you died before the age of 75. As the government intends to end the current pensions IHT exemption from April 2027 any unused pensions, if your estate is more than the applicable IHT nil rate bands would be liable for IHT. Therefore it could be a further reason to use these funds to pay an Annual Allowance tax charges due. The inter-spousal transfers of pensions on death will remain exempt from IHT.
It may be sensible to pay any annual allowance liability from Defined Contributions (DC) arrangements if your retirement planning determines that the NHS pension scheme will be your initial crystallisation event. Keep in mind, that NHS pension benefits are index-linked in retirement, with the compounding effect of indexation being greater for higher starting amounts. Using DC funds to pay annual allowance tax liabilities can help preserve the value of your NHS pension benefits.
However, a significant drawback exists when using DC arrangements for this purpose. While it is theoretically possible, very few providers offer the facility to pay annual allowance tax liabilities. Many of these accounts are older, and the providers lack the systems to handle such payments. Furthermore, it’s often not in the provider’s interest to facilitate payments for tax liabilities stemming from 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 a full range 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 involves a cost, which should be carefully considered alongside other factors before transferring pension benefits. If you’d like to explore this avenue, feel free to get in touch.
Let’s summarise
The combination of these factors – such as net pension reduction, and member capital/savings remaining available for the member rather than paying to HMRC immediately for the annual allowance liability makes the NHS Pension Scheme Pays, a worthwhile consideration.
However, each pension member’s circumstances are unique, and the younger the member the greater the effect of compounding interest charges on the notional negative DC account.
Thank you for sticking with us through this detailed and complex article, but hopefully, you now have sufficient information to make an informed decision. However, given the importance of this topic, we strongly recommend seeking specialist independent financial advice before making any final decisions.
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 lets you use unused annual allowance from the past three tax years if you were a member of a registered pension scheme. To use Carry Forward, you must first exhaust all of your current tax year’s annual allowance, and then any unused annual allowances from the three previous tax years can be utilised.