Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Matthew Brown, Private Client Partner, Thomas Miller Investment explains how a fall in the Consumer Prices Index is bad news for those in defined benefit pension scheme, comments.
People who are active members of defined benefit scheme should take note of the latest negative CPI figures, which could lead to a costly tax bill. This will exacerbate those are facing a reduced annual allowance and could mean that getting a pay rise leads to a large tax bill.
High earners now potentially face a double pension whammy
Each year we all have an Annual Allowance, where pension contributions up to this level currently receive tax relief.
This is set at £40,000, unless you have taxable income of more than £110,000 a year, in which case this allowance reduces on a pre-determined basis to as little as £10,000 for those earning more than £210,000.
For those in Money Purchase pensions the definition of a pension contribution, for Annual Allowance purposes, is straightforward. It is simply the physical contribution made (ignoring pension input periods – which is an entirely different topic altogether) into the pension in the year in question.
For active defined benefit scheme members the calculation is more complex. The pension entitlement at the start of the year is deducted from the pension entitlement at the end of the year and the difference is multiplied by 16. An important factor that limits this “deemed contribution” is that the pension entitlement at the start of the year is adjusted for inflation.
This is a problem for the 2016/17 tax year as the inflation figure used will be the CPI figure for the year to September 2015, which fell by 0.1%. As there has been no increase in CPI over this period, in fact it is slightly down, there will be no increase in the starting figure. This limits any increase in the pension entitlement to just £2,500 for those with an Annual Allowance of £40,000.
Above this figure, unless individuals have any unused carry forward annual allowances, they will face an Income Tax charge on the excess contribution. Not only will the pension entitlement increase by an additional years’ accrual, but any pay rise can also have a dramatic effect; be aware, that promotion may well turn out to be a double-edged sword.
High earners now potentially face a double whammy of a vastly reduced Annual Allowance, with no inflationary increases being applied to the calculation itself. Individuals with a £10,000 Annual Allowance will only be able to have a pension entitlement increase of £625 before tax bites. They will also be liable to tax, at the highest rate, on any deemed excess contribution, currently 45%.
If you are caught by these changes in pension rules, you should speak to a chartered financial planner who can help you navigate this convoluted system.
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