Paying taxes is part of our contribution to society but, writes Jacqueline Clezy, surely nobody wants to make tax-efficient pension provision that turns out to be less efficient than actually planned
The end of the tax year has been and gone, P60s have landed on doormats and, with no changes to the pension tax relief rules, it is now possible to work out accurate relevant earnings – especially so for those clients with variable earnings, such as those who are self-employed.
But what happens if these calculations show that pension contributions made during 2018/19 are not fully entitled to tax relief? It is important to remember that tax relief limits and the annual allowance rules work separately. Here is a rundown of the basics.
Tax relief on pension contributions
An individual paying a pension contribution is entitled to tax relief on a basic amount of £3,600 gross or up to 100% of their relevant earnings in the tax year the contribution is paid, if that is higher. Any contribution in excess of this amount is not entitled to any tax relief. Pension contributions can be paid at any time in the tax year, based on anticipated earnings for the whole tax year.
So where a large contribution is paid early in the tax year but subsequently the earnings to make it eligible for tax relief do not materialise – for example, employment ends unexpectedly or service contracts are not renewed – HMRC guidance allows a refund of the excess contribution. This is known as ‘refund of excess contributions lump sum’.
Where there are no relevant earnings and the member has paid a gross contribution – for example, to a retirement annuity contract (RAC) or s226 plan – tax relief is claimed by deducting the contribution amount from taxable income. Where this is nil, then a full refund of the contribution is permitted – providing the plan terms and conditions allow it – as the full contribution is deemed as non-relievable.
If the pension contribution has, however, been paid to a scheme that operates ‘relief at source’ (RAS) then, even if there are no relevant earnings, they are not able to refund the first £3,600 gross/£2,880 net of any pension contribution, as this is eligible for tax relief even where relevant earnings are nil.
Let’s not forget those who make pension contributions under ‘net pay’ rules. Net pay gives ‘tax relief’ by allowing a reduction in taxable income. You need to watch for low-earners though as they only benefit to the extent they would actually be due to pay tax.
Someone who earns £10,000, and pays 5% (£500 a year) by net pay has taxable income of £9,500. You would then take off the personal allowance, on which they do not pay any tax, and this means there is no income subject to tax. The amount of tax due cannot reduce below £0.
There is no tax relief gained by a net pay member where their taxable income is less than the personal allowance. This is in contrast to an RAS member where their pension contribution is grossed up by the basic rate of 20%. Of course, it is likely the net pay scheme will also have at least a matching employer contribution, more than compensating for the lack of tax relief.
Bear in mind the client must usually wait until after the end of the tax year in which the contribution was paid to claim any refund. The final relevant earnings figure needs to be established so the excess amount can be accurately calculated.
This rules out an individual who initially pays a contribution to an RAC in the current tax year from asking for a refund under these rules, then using this payment to make a contribution to a personal pension scheme that operates RAS in the same tax year instead.
If someone who contributes to an RAC later realises there is no tax relief gained (due to insufficient relevant earnings as covered earlier), although they may ask for a refund under these rules, the refund payment cannot be paid until the following tax year. As individuals are only entitled to tax relief in the tax year the contribution is actually paid, they cannot obtain a refund and make a new contribution in respect of the previous tax year’s allowances.
Under the self-assessment rules, if a mistake has been made, you can only usually claim a refund up to four years after the end of the tax year it relates to and HMRC provide guidance on the process to use. However, a ‘refund of excess contributions lump sum’ can be paid up to six full tax years after the excess contribution was paid.
|Example: When is a refund allowed
Mark is married, lives in Devon and uses his wife’s income for all day-to-day living expenses. He is self-employed and is expected to have taxable earnings of £30,000 in tax year 2018/19. On 10 April 2018 he paid a net pension contribution of £24,000 to his personal pension plan, which operates RAS.
Later that week he had an accident and was unable to work for one month. This reduced his taxable earnings by £2,500, can Mark ask for a refund of part of his pension contribution?
At the end of the 2018/19 tax year, Mark’s actual taxable earnings were only £27,500 and, as he has made a gross pension contribution in excess of his relevant earnings, he can ask for a refund of excess contributions lump sum. His pension scheme administrator – having received suitable earnings evidence – must return the £500 excess tax relief claimed through ‘relief at source’ to HMRC. If its scheme rules permit, HMRC can refund the £2,000 overpayment to Mark.
If this refund is paid, then Mark’s annual allowance test uses a pension input amount of £27,500. It would be £29,500 had there been no refund.
|Example: When a refund is not allowed
Bridget lives in Cornwall and is self–employed with anticipated earnings of £30,000 a year. She made a £24,000 net pension contribution on 10 April 2018.
Bridget had, however, overlooked the letter from her scheme telling her that, when she took a small uncrystallised funds pension lump sum (UFPLS) to pay debts in January 2018, this triggered the money purchase annual allowance. Now knowing she should have capped her defined contribution pension savings (for tax year 2018/19) at £4,000, can Bridget ask for a refund?
No. Bridget has paid an eligible contribution in relation to the tax relief rules, but has exceeded her annual allowance.
The annual allowance rules do not allow any refunds of annual allowance excess to reduce or avoid an annual allowance charge. With all the changes to annual allowance members could be exceeding the money purchase annual allowance (MPAA), the standard annual allowance or their personalised tapered annual allowance. Any charge is paid through self-assessment.
Where it is the standard or tapered annual allowance that is exceeded, you would deduct all available carry forward to calculate the chargeable amount. There is no option to use carry forward to increase the MPAA limit.
Any contribution refunded under these circumstances would be regarded as an unauthorised payment from the pension scheme and, as such, would attract hefty tax charges and it would not reduce the member’s pension input amount for the annual allowance test so there would be AA charges due anyway.
So, in Bridget’s case above, the pension contribution is valid and should remain in the scheme. She has exceeded her annual allowance by £26,000 (£30,000 paid less the MPAA limit of £4,000). Bridget must report and pay the relevant annual allowance excess charge due in her self-assessment tax return.
There is no option for any amount of employer contribution to be refunded under the ‘Refund of excess contributions lump sum’ rules, as a member’s relevant earnings figure is not a cap for corporation tax relief on employer pension contributions.
For completeness, if Bridget had instead run her own limited company and followed her accountant’s advice to take £30,000 profit from the business and paid this to her pension scheme as an employer pension contribution, this is an allowable deduction for corporation tax relief.
Bridget would still, however, have an annual allowance excess of £26,000 and she would personally be responsible (not her business as they are separate legal entities) for paying the annual allowance charge even though this is in respect of her employer’s contribution. The annual allowance is the member’s limit and does not affect the employer’s corporation tax relief.
Aside from the above scenarios, there are a few situations that can be considered genuine errors that would allow contributions to be refunded. Perhaps the most common would be where a member asks their bank or building society to stop a direct debit for future contributions but this is not actioned in time and further payments are made to the scheme. As the scheme should never have received these contributions, they are allowed to return the payments.
Similarly, where a member opts out of auto-enrolment within the 30 day deadline, then they are treated as never having joined the workplace pension scheme meaning the scheme is allowed to return the payments received.
In these scenarios, the refund of contributions means there is no pension input amount to be tested for annual allowance purposes. Also, as the contributions are regarded as never having been paid, the refund could mean the member is eligible to apply for Fixed Protection 2016, if all other criteria are met.
Know your limits
Ultimately, if clients want to take advantage of making an early pension contribution, it is important they know their limits before the pension contribution is paid as, in most cases, an overpayment cannot be claimed back. So, if the client has to pay a tax charge, that is simply donating more of their hard-earned cash to HMRC than is necessary.
Paying our taxes is part of our contribution to society but does anyone really want to make tax -efficient pension provision which turns out to be less efficient than we actually planned.
Jacqueline Clezy is technical manager at Prudential UK