Of all the issues brought to us by our members, there is probably none which causes more upset, misunderstanding, and sometimes anger, than Annual Allowance. In the last few years it has seemingly come from nowhere to become a major source of concern. Here are some Q&As about it, with some good advice.
Q. What is Annual Allowance?
A. It is not an allowance at all really, it’s a tax. A tax on your pension increase in a particular tax year. It applies to all pension schemes. Very simply, if that increase in value exceeds £40,000 (which is the current ‘annual allowance’) you will pay tax on the increase at your marginal tax rate – which will generally be 40% (although occasionally 45% of course).
Q. What is the history behind this?
A. It was first introduced in April 2006. It was introduced because pension investment is tax efficient and the Government did not want people taking too much advantage of this. The allowance was then set at £215,000 which did not affect many people in the Armed Forces as very few would have had pensions that would grow by that much. And in the years following it became even higher – climbing to £255K in the financial year 2011. But then it reduced to £50,000 in 2011/12 and that was the first time the Armed Forces really became aware of it. Since 2014/15 it has been £40,000.
Q. How is the pension value calculated?
A. If you are in a defined contribution scheme it is very simple – it will just be the amount of money you have paid into the scheme during the year (and if you approach the £40K limit then you can turn off the tap and stop contributing). But for defined benefit schemes like the Armed Forces schemes it is not so straightforward – you do not pay in, but your pension’s growth is based on things like your rank, salary, length of employment and other variables. How it works is that the difference between your pension value at the beginning of the tax year and at the end is multiplied by 16 – this is a Government Actuary’s Department figure based on the calculation that were you in a private pension scheme you would have to pay £16 in for every £1 pension growth – which incidentally shows just how difficult it would be to fund our pension benefits through a private sector type scheme. For schemes with an automatic lump sum payment, that also needs to be taken into consideration too.
Q. It seems Complicated!
A. Yes, but you don’t have to do it yourself – the calculation is done for you by Veterans UK. But it does mean that you can breach the £40,000 threshold – and therefore become liable for tax – without really knowing about it
Q. So who is affected now?
A. Higher earners will be vulnerable but it’s not as simple as that. If you were just on the 2015 pension scheme to get accruals anywhere near £40,000 you have to be earning just short of £120K, and very few people earn that sort of money. However, many people serving now have protected rights under the old schemes and here it gets tricky. Because of the way the 1975 scheme behaves there will sometimes be significant uplifts in pension awards partway through a tax year – these can lead to an annual allowance breach. It is wrong to assume a simple read across to rank; we find that no two cases are the same.
Q. Is there any protection?
A. Yes! You can carry forward any unused annual allowance from the previous three years. So if you have not exceeded the annual allowance threshold in those years you can take the allowance you did not use up and add it to the allowance for the current year. And your pensions increase will be matched against that higher number – this could give you much more protection and reduce your vulnerability.
Q. So that means many people who breach in a single year will not face a tax charge?
A. Yes, last year about 4,000 people were notified that they had exceeded the limit in-year but, because of the carry forward, well over 3,000 of them did not face a charge.
Q. What is the annual cycle of this?
A. The key measurement is between pension value at the beginning and at the end of the tax year – this is called the Pension Input Period (PIP). So beginning in April Veterans UK look at the two figures, work out the difference, multiply by the GAD factors. They can then see who has breached the £40,000 allowance. And then they write to all affected individuals. These letters would go out round about September – about 4,000 last year. So that if people submit paper self-assessment tax returns they will have this information ready for their tax declaration. If you have breached but there is no charge, because of carry over, you simply acknowledge the letter; if you have a charge then you have to take this up with HMRC. But of course Veterans UK only have visibility of pensions growth from your Armed Forces pension - the reason they tell everyone who has breached even if they do not have a charge is that those people may have other pension accruals that need to then be incorporated into the figures on their tax return. So you must declare to Glasgow whether you have other pensions.
Q. So for some people this can be a big shock!
A. Yes, we see that a lot in the Society. Last year a number of people got in touch and said, “I have received this letter; I do not understand it, it is just not fair! It cannot possibly be right can it?” But in most cases it is right and the shock is because they were unaware that this was in the background.
Q. What do you say when people tell you they are shocked and upset about this?
A. First we say they must send us the breach notification; we need visibility of the letter so we can explain it to them. We also explain to them about ‘Scheme Pays’.
Q. What is Scheme Pays?
A. If the tax bill is under £2,000 then you just have to take care of it yourself. But if it is over £2,000 you can go for something called ‘Scheme Pays’, which essentially means the MoD settles the bill on your behalf and you pay back the MoD from your pension when it comes into payment over the period of your lifetime. There are advantages and disadvantages in doing this, and we often talk our members through the options.
Q. Many people say it is not worth me being promoted because of this!
A. You will always be better off as a result of promotion. We have had people talk about leaving the services to avoid the charge, opting out of the scheme or joining a different scheme. None of these are particularly good ideas. Someone who is promoted, and breaches, and pays a tax charge, will be better off financially than someone who does none of those things. What I say to people is it’s like joining the services and saying “I will stay as a corporal throughout my entire career because by doing so I will never pay tax at 40% – that’ll show ‘em!” Besides, if you leave to avoid this you will almost certainly have to take up some other career with a pension scheme which will be also subjected to annual allowance – it does not just apply exclusively to the Armed Forces!
Q. What is your advice to those who may be affected by this, or fear they may get a letter.
A. Do not panic! If you receive a letter and you are a member, send it to us – we will check it and we will then explain to you how this came about, and explain the options to you if you have a charge. And if you have not yet got a letter do nothing – let Veterans UK do their work. If you do receive a letter then give us a shout – but do not lose sleep over it.