The Tapered Annual Allowance affects employees with adjusted income exceeding £150,000 and threshold income that exceeds £110,000. The Annual allowance will gradually reduce from £40,000 to £10,000 p.a. where adjusted earnings exceed £210.000.

This new rule effective from 6 April 2016 may at first sight only appear to impact the 300,000 or so individuals lucky enough to earn £150,000 or more but as Mark Soper explains it has caused much consternation and confusion amongst employers and their HR departments.

So what is the fuss all about?  Well the short answer is, employers may need to change the compensation package of high earners and treat them differently to other staff members – something that HR executives do not like.

The chief problems arising from this complex rule are:

1. Income definitions – Adjusted income is taxable income from all sources including, for example, rental income, interest and dividend income. Employers will simply not know whether an employee will have any of these other types of income and if when added to company earnings will exceed £150,000 in any particular tax year. 
2. Multiple pension arrangements – Some employees may be contributing personal pension contributions to other personal pension plans/SIPPs and employers cannot assume that the contributions paid into its own pension plan is the total pension contribution being paid by an employee in any particular tax year. 
3. Timing – Some employees may not be able to calculate their adjusted income until after the tax year has ended, by which time the employer pension contributions will have already been paid into the pension plan. Unless advance earnings calculations have been made, an employee may not know and cannot plan for an additional personal tax charge.

The annual allowance tax charge is a personal tax charge on the employee – the charge is calculated by adding the excessive level of pension contributions to an individual’s taxable income – in effect, the excess is subject to their marginal rate of income tax.

Avoiding the tax – Carry Forward of Unused Annual Allowance

In a tax year where an employee has been subject to a tapering of the annual allowance and  excessive contributions have been paid, it will be possible for the employee to avoid the annual allowance tax charge if the employee can carry forward unused annual allowance from one or more of the three prior tax years. Again, as mentioned in 2. above, employers cannot rely upon an employee having any unused Annual Allowance in previous years as the employee may have contributed to other pension plans unknown to the employer.

An employee may not know until relatively late in the tax year if total earnings are likely to exceed £150,000, particularly if discretionary bonuses are paid and there may not be time to claim the unused allowance from prior years. 

What Options are Available to Employers

There are a number of routes that employers may consider in response to the forthcoming changes and it is important to highlight that no single solution is likely to have universal appeal to the high earners that may be impacted by the reduced Annual Allowance.

Employers could offer a menu of options so that each individual employee (or impacted high earners only) select the most appropriate option to fit their personal circumstances.  This will inevitably increase HR administration and it is possible that the most appropriate option in one tax year may not necessarily be so in the following year.

1. Make no change

Employers are not obliged to offer alternatives or restrict payments to its Pension Plan. Employees subject to the Annual Allowance Tax Charge will still benefit from the contributions added to their pension fund and an employee’s pension fund will grow as before. However, the potential tax charge will reduce the pension plan’s tax-effectiveness.

Employees may not know about the change in the rules nor if they are likely to be impacted. The amount and timing of the tax charge and the possibility to avoid it using the carry forward rules may not be known by some employees. HR departments are likely to communicate the changes to employees and may go a step further and provide access to a financial adviser but there ios no obligation on the employer to do so.

 2.    Limit the Pension Contributions effective from 6 April 2016

Employers could decide to limit pension contributions to the plan effective from 6 April 2016 to £10,000 p.a. with any additional contributions up to the contractual rate only added following a specific employee request to do so i.e. the employee sets an individual contribution limit.

3.    Pay Cash In Lieu of Excessive Pension Contributions

In lieu of any pension contribution given up, employers may choose to increase an employee’s pay. The increase in pay will be subject to UK Income Tax and NIC. As the employer’s rate of NIC is 13.8% this method would create an additional cost to employers so it may choose to reduce any additional pay to 87p for every £1 of pension contribution given up.  Employees would pay NIC of 1.0% on the additional pay.

Whilst the rate of income tax is the same on either an increase in pay or on an excessive pension contribution, some employees may prefer the immediate access of additional net pay taxed at source rather than the worry of paying additional income tax in the future.  However, employers will have no control over how the additional pay is used by the employee and if spent rather than saved/invested this could have a detrimental effect on an employee’s long-term retirement savings.

Employers will need to be careful how it presents the additional pay.  If it is added to basic pay this could have an impact on an employee’s other potential benefits e.g. life cover, PHI, sick pay and/or redundancy pay.

4.    Set Up Additional Savings Plan

Employers may decide to set up an additional employer-paid savings/investment scheme such as a workplace ISA to run alongside its pension plan. The gross contributions paid by an employer on behalf of an employee are subject to immediate tax and NIC deduction in the same way as additional pay would be.  This additional tax charge will reduce the net take home pay for employees.

A workplace savings scheme such as an ISA is more structured than additional pay and an employee may be more likely to view this arrangement as part of a long-term savings/investment strategy.