Feature / Finance explained: Pension benefit taxes (UPDATED)

(This article first appeared in the February issue of Healthcare Finance. Following requests from readers, the table included with the article has been revised to provide further detail on the calculation.)

PENSION SCHEMES ARE undergoing profound changes, writes James Beardmore. State pension age will increase to 66 for many. Lord Hutton’s Pensions Commission report this year could recommend higher member contributions and a cut in benefit levels in public sector pension schemes. The NHS Pension Scheme ‘pension choice’ exercise is also under way.

The biggest worry, however, for senior, newly promoted or long-serving employees could be the significant reductions in the tax-free thresholds for building up pensions that will soon apply.

From April 2011, the tax-free limit of the value of pension that can be earned in a year is £50,000 after any inflation increase. For tax purposes the pension entitlement is valued using a conversion factor of 16. Consequently the tax-free limit of annual pension entitlement is 1/16th of the £50,000 limit, being only £3,125 per annum plus inflation. This figure reduces to £2,632 per annum where there is an attaching retirement cash sum of three times the pension. This means that many more people will be affected than just those at the top of the organisation.

An individual will be subject to income tax at marginal rate on any excess, unless any unused allowance from previous years can be used. In the example (right), the individual would be subject to more than £9,000 extra income tax, simply by being a scheme member and receiving a pay increase.

The calculations can become quite complicated, but will generally reflect the difference in benefits accrued at the end of the year compared with the beginning of the year after offsetting inflation. This calculation does not depend on the actual contributions paid into the scheme over the year. The government’s preliminary consultation proposed that an individual

would settle the first slice of tax (possibly up to £6,000) after the tax year with the balance met, optionally, by deduction from scheme benefits. This tax charge can more than wipe out the pay rise for the year.

From April 2012, tax charges also apply at retirement if the total annual pension built up is more than £75,000 per annum (less where there is an additional retirement cash sum) unless the individual is able to use one of the limited forms of protection. The direct obligations on employers will only be to provide earnings information to enable pension schemes to notify members of benefit increases, as the tax liability is a matter for individuals.

Many employers will, however, review their human resources strategy to minimise adverse reactions. This may involve identifying groups of staff likely to be affected, considering remuneration options to mitigate tax charges, or undertaking staff communications to increase awareness of the need to plan for the changes.

* James Beardmore is principal actuary at KPMG Pensions

* Other factors could have an impact including the various forms of protection that an individual may be able to use – notably carry forward provisions in relation to the annual allowance charge. The example is for guidance only and individuals should take their own independent financial advice.