How public sector workers can sidestep pension tax traps

Senior public sector workers are at risk of breaching tax-free pension contribution limits and incurring heavy penalties.

Doctors and other public sector workers such as school heads and top civil servants face punishing tax penalties for inadvertently breaching the legal limit for tax-free annual contributions to their pensions.

The situation is so bad that hospital consultants and GPs, who invariably work extra shifts to cover NHS staff shortfalls, are effectively working for free once their tax penalties have been taken into account.

The government allows no more than £40,000 to be contributed to any individual’s pension in one year – the annual allowance. Breaches trigger a marginal-rate tax charge of between 20% and 45%.

- Isa millionaires: the fortune formula

Tax ambush

For public sector workers enrolled in defined benefit pension schemes – where payouts are based on salary – calculating whether they will breach this limit is challenging, because the annual allowance is measured against the change in the value of accrued benefits over the year, not simply the cash contributions the employee and their employer have made in the period.

This change in value is calculated by working out the difference between the opening value of pension benefits at the start of the pension contribution year and the closing value at the end of the year. This exercise is somewhat retrospective, however, as it’s only possible to calculate a tax liability accurately once it has been incurred and nothing can be done to change it.

If you have had a big pay rise in the past year or moved from part-time to full-time work, you will be particularly at risk of exceeding the annual allowance. That’s because the rise in pension value against which the allowance is measured is not the monetary amount by which your earnings increased over the year, but the pay rise’s impact on your (nominal annual) pension benefits multiplied by all your years of service.

The government’s introduction of annual allowance tapering in 2016 for people who earn more than £150,000 (including pension contributions) has made matters even more complicated.

For every £2 of income they earn above £150,000 a year, £1 of annual allowance is lost. The maximum loss is £30,000, so anyone earning more than £210,000 can benefit from an increase of just £10,000 in their pension’s value over a year before penalties start to kick in.

Coping with the limit will be even more difficult this year. Previously, it was possible to carry forward any non-tapered annual allowance from one year to the next, but not anymore.

The British Medical Association (BMA) has been lobbying the government over the issue. It argues that if doctors are penalised for covering vacancies or helping reduce waiting times, the NHS will reach crisis point.

- Pension tax fears blamed for spiralling NHS waiting lists

BMA number-crunching shows that a part-time GP takes home just £338 a year less than a full-time GP, despite working half the hours, primarily because of the pension tax charges incurred by full-time GPs. Small wonder that two-thirds of GPs now retire early – twice the level of five years ago.

Thousands of other workers in occupations such as civil servant or teacher – arguably jobs where relatively generous pensions have long been used to attract people to work for relatively modest salaries – are also falling foul of the annual allowance limit, often unwittingly.

Public sector workers caught out can usually access a facility offered by their pension scheme to settle any penalty out of their fund. However, interest (typically a hefty 2.4% above inflation) will be added to their account and will continue to roll up over the years. This loan cannot be repaid prior to their retirement date, so once they have taken it out, they are stuck with a debt that will compound over many years.

Some public sector schemes, such as those run by local government, offer a 50/50 pension that allows members to pay just half the usual contributions for a set period. They receive commensurately lower benefits in retirement.

The NHS is now considering a scheme that would allow staff to pay half their usual pension contribution into a scheme for up to 10 years. Phillip de Warren-Penny, who sits on the BMA’s consultants committee, says the NHS is also exploring a top-up scheme for doctors who need to leave defined benefit schemes because they are incurring penalties. The new arrangement will channel employer contributions that would otherwise be lost.

De Warren-Penny says almost all hospital consultants take on extra shifts to prop up the NHS and that all full-time consultants will exceed their annual pension contribution tax-free allowance over the next four years.

Consequently, the BMA is developing a calculator (due to launch on its website shortly) that can help consultants calculate their liabilities and provide answers to ‘what if’ questions that will enable them to understand the impact on their tax positions of cutting their shifts or responsibilities. A calculator for GPs will follow.

- Ask Money: will my idea for passing on a buy-to-let flat work?

Double trouble

A second pension cap is also proving a headache for public sector workers. The lifetime allowance (LTA) – the amount you can accrue tax-free in pensions over your lifetime – has been progressively cut by the government, from £1.8 million in 2011/12 to £1.055 million currently. Above this limit, savers face a tax penalty on overpayments of 55% on lump sums and 25% on income. Again, working out whether you are likely to breach this limit is tricky, as your pension is based on your salary and imponderables such as your eventual retirement date.

The annual and lifetime allowances are all the more problematic for public sector scheme members because their schemes were once based on their final salaries but are now tied to their careeraverage salaries. The NHS is at the epicentre of the problem because of the risk to the health service if the staff propping it up cut their hours, and also because the NHS has the most complicated arrangements, with some doctors being members of up to three schemes.

Many people assume that the LTA is set so high that it will never apply to them. However, anyone who is on track for a defined benefit pension of more than £51,000 a year is likely to be affected.

A rule of thumb for working out whether you are likely to exceed the LTA is to take the expected value of your annual pension and multiply it by 20. Any tax-free cash lump sum that you will receive in addition to your expected annual pension must be added to this figure.

It is possible to apply to HMRC for LTA protection. If you have made contributions since April 2016, you can only apply for Individual Protection 2016, which protects your LTA at the value of your pension savings as at 5 April 2016 or at £1.25 million, whichever is lowest. There is no application deadline, but you must apply online for protection and receive an HMRC reference number before you take your benefits.

- Master financial fear to avoid being left in the lurch

You might also want to take your 25% tax-free lump sum entitlement as soon as you can, so that any subsequent growth in the value of this element will be outside the LTA.

There are good reasons to save into a pension scheme, even if you exceed the tax-free allowances. Public sector employers typically offer generous death-in-service and dependents’ benefits that could be reduced if you opt out. The civil service, for instance, pays out for children up to the age of 18 and up to age 23 if they are in full-time education.

Bear in mind, however, that death-in-service and dependents’ benefits count towards the pension holder’s LTA; any excess is taxable at the usual rate – lump sums at 55%, and income at 25% – but is paid by the recipients on top of their own marginal rates. A typical death-in-service benefit is around four times salary; if you die before you retire, this substantial amount counts towards your LTA and might take it over the cap, leaving your heirs to pay tax on any excess.

Opting out could also disqualify you from the protections given to longstanding members of pension schemes, should disadvantageous changes be introduced – something we have seen frequently in recent years – while the increase in after-tax income if you opt out could push you into a higher-rate tax band or result in you losing child benefit.

One final quirk to consider is that anyone who took out Fixed Protection 2016 could lose it if they change roles and receive a new death-in-service benefits package. In some cases these have been viewed by HMRC as an addition to the pension fund, thereby invalidating the protection.

- Give while you’re still living and reduce your inheritance tax bill

How to work out your annual allowance in a defined benefit scheme

You need to work out the difference in value between the benefits you built up last year and those amassed this year.

Step 1: Work out last year’s value. Using your pension statements, find out the amount of pension you built up last year and multiply this amount by 16. Add to that figure any lump sum entitlement built up at the same valuation date, and then increase the combined sum by the rate of inflation using the CPI figure (available from the ONS for the September prior to your valuation date.

Step 2: Work out this year’s value. Take the total amount of annual pension built up at the end of the latest year and multiply this by 16. Then add on any lump sum entitlement built up as at the same valuation date.

Step 3: Calculate your pension value increase. Take away the opening value from the closing value to work out the difference between the two figures and compare this amount with the £40,000 annual allowance.

There is a worked example on the government’s pensions advisory service website. Your scheme may be able to give you your ‘pension input amount’, to calculate the value of accrued benefits during the year.