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Tax / Technical: Annual Allowance issues for DB members

7 March 2018

Fiona Tait, technical director, Intelligent Pensions looks at the complexity of end of year tax calculations for clients with DB pensions when it comes to the Annual Allowance – and uses a case study to explain the system.

It’s that time of year again, four weeks to go and clients want to know how much they can put in their pension without incurring an Annual Allowance (AA) tax charge.

For clients with defined contribution (DC) plans the situation is straightforward enough, now that we have Pension Input Periods aligned to the tax year, but what about those with defined benefit (DB) pensions, and what if they are also subject to the AA taper and/or the money purchase annual allowance (MPAA)?

In a DB arrangement, contributions are not allocated to individuals and so in order to calculate the Pension Input Amount (PIA) it is necessary to calculate the increase in the value of a member’s entitlement over the year in question:

1. Calculate the opening value of the member’s pension

Step 1 – Calculate the value of the pension built at the start of the year

Step 2 – Multiple this value by 16

Step 3 – Add any additional lump sum value

Step 4 – Increase the total value by CPI

2. Calculate the closing value of the member’s pension

Step 1 – Calculate the pension built up by the end of the year

Step 2 – Multiply by 16

Step 3 – Add any additional lump sum value

Step 4 – adjust for any transfers in/out, debits/credits or previous AA tax charge via “scheme pays”

3. The Pension Input Amount = (1) minus (2).

For example:

Sarah wants to contribute to her SIPP in 2017/18, however she is also a member of her employer’s final salary scheme. She has 25 years’ service at the start of the year and a pensionable salary of £80,000. At the end of the year her salary has risen to £82,400. The accrual rate is n/80^th plus a lump sum of 3n/80ths

Starting value:

• 16 x (25/80 x £80,000
• plus 3 x (25/80 x £80,000)
• £400,000 + £75,000 = £475,000
• Adjusted for CPI = £475,000 x 1.01 = £479,750

Closing Value:

• 16 x (26/80 x £82,400)
• plus 3 x (26/80 x £82,400)
• £428,480 + £80,340 = £508,820

Pension Input Amount:

• £508,820 – £480,700 = £29,070
• Available AA = £40,000 – £29,070 = £10,930

In this example Sarah has £10,930 unused AA in 2017/8, but that might not be the end of the story. She could be subject to additional restrictions and/or have unused AA from previous tax years, and so it is important to gather all the facts and to understand how they interact.

Interaction of the MPAA, the AA Taper and carry forward

1. MPAA

The MPAA reduces tax relievable contributions into DC plans to £4,000, creating an alternative AA of £36,000 for DB contributions (note – the MPAA was £10,000 in 2015/16 and 2016/17, resulting in an Alternative AA of £30,000).

This makes it necessary to carry out 2 tests:

• any DC PIA excess over £4,000 plus any excess DB PIA over £36,000
• any excess total PIA over £40,000.

The tax charge will be the higher of these two amounts. For example, if Sarah had forgotten that she had triggered the MPAA her tax charge would apply to £6,930 (£10,930 – £4,000), as neither the alternative AA or total AA has been breached (both values = 0).

2. AA Taper

Clients who are subject to the AA taper will have their AA reduced, resulting in a reduced AA in each year that it applies.

If the MPAA has been triggered the reduction applies to the alternative AA, effectively resulting in a lower overall limit within which DC contributions are limited to £4,000.

Carry forward may still be used however the amount carried forward would be limited by the taper applicable in that year.  It should also be noted that up to £40,000 unused AA can be carried forward from 2014/15 and 2015/16 regardless of earnings since the taper had not yet been introduced.

3. Carry Forward

If the AA in the current tax year has been fully utilised, unused AA from the previous 3 tax years may be carried forward to increase the overall AA available.

It is possible to carry forward unused AA to a year where the MPAA applies, but it will be added to the alternative AA and not the MPAA. Carry forward from years in which the MPAA applies will be limited to the unused alternative AA; any shortfall in DC contributions may not be carried forward.

In the above example even if Sarah had made no DC contributions in the last 3 tax years she could only carry forward any unused alternative AA and her MPAA in 2017/18 would remain at £4,000, thus limiting her ability to invest in her SIPP.

The complexity of the above proves the value and need of professional financial advice, and may even help if you have to justify this to clients.