The madness of high-earners’ pension rules

Pensioner with lots of cash © Getty Images
it won’t be easy to shower yourself in cash via your pension

I wrote a few months ago that for all the bitching and whining about it, the UK pension system is now pretty straightforward. You open an account – or your employer does it for you – money goes in every month; you get full income tax relief on that cash on the way in; and it all gets invested – by you, your wealth manager or your company’s default scheme.

On the way out – after you are 55 – you get to withdraw 25% of the cash tax-free and withdraw the rest as and when you want, subject to your marginal rate of income tax. Anything left over can be left to your heirs free of inheritance tax (IHT). It is simple – and from a tax point of view at least, generous stuff.

But the problem with pensions is that they are not simple for everyone. You only have to be earning quite a high income, be in quite a good defined-benefit scheme, or be quite good at investing to run into trouble.

For some years now, I have been receiving regular emails from a middle-aged man working at the top of middle management for a large listed UK company with a middling brand reputation. Let’s call him Frank (I don’t suppose he is keen for his employers to read about his financial feelings here).

Frank is lucky in lots of ways (talk to someone about their finances, and in the end you learn a lot about them). He has a good job with what most people would consider an excellent salary. He has a defined benefit pension (so regardless of investment returns, he will get a guaranteed inflation-linked income in retirement). He travels a lot and his family sound nice.

But he is also unlucky – he is good enough at and interested enough in maths to be one of the few people who understands what the pension relief taper (which cuts the amount you can save into a pension from £40,000 to £10,000 as your income rises from £150,000 to £210,000) and the lifetime allowance (which penalises you if the assets in your pension wrapper grow to be worth more than £1m) are doing to his tax bill.

That means that his emails over the past year have become increasingly anguished. He has just received a small pay rise. It comes to just over £2,000 a year. By his reckoning it will also land him with a tax bill of just over £8,000. “Thank God”, he wrote to me sadly, “that I didn’t do as well as I hoped this year.”

You’ll be confused. How can a pay rise mean a net income loss – or an effective marginal income tax rate of more than 300%? Easy. There is the extra income tax on the gross amount. Then there is the fact that the rise in salary, plus inflation linkage, automatically means that there is a rise of about £39,000 to the assumed value of his pension pot. That value is added to his income to create the adjusted income used for application of the taper. That leaves him with a £10,000 allowance.

But the uplift in the value of his future pension comes to way more than that (that’s the £39,000 for tax purposes). There are complicated calculations in here (it depends on length of service, what basis the defined benefit is calculated on, the rate of inflation and other factors. The simplest explanation of the tax implications of tapering on DB schemes I could find comes from Axa Wealth and runs to nine pages, to give you an idea). Frank has some relief in that he can carry over some annual allowance from last year.

The upshot is that he must pay income tax at his marginal rate (45%) on about £16,000 of new pension assets. This is shocking now, but he reckons it will madden him even more later – he will have to pay income tax when he finally receives his pension too.

We all often complain about double taxation but actually, paying income tax twice on the very same bit of money is about as nuts as it gets. Frank’s response to this is to pray he never gets another pay rise. “Will I now take on more work or even hope for a good annual performance review if all that does is lead to a larger loss in my net income?” he asks. “Nope.” Doesn’t bode well for managerial productivity, does it?

You might not have huge sympathy for Frank. After all, he will in the end get a £40,000-odd annual pension (I actually dream about waking up and finding I have one of these). And he doesn’t have to pay the tax charge up front: if your extra liability is more than £2,000 a year you can ask the pension scheme to pay it instead – and reduce your future benefits accordingly.

But, nonetheless, his case should make it very clear that if a pension is considered part of your pay, the taper and the reduced lifetime allowance (this will make his situation worse in the not too distant future by the way) act as new and extraordinarily high marginal tax rates. What does 45% matter if you are also being charged 300%?

The taper is also a nightmare for those of us managing our own defined contribution pensions (although we can at least easily avoid the tax charge by just not contributing). I would go so far as to say that of all the personal finance policies I have seen in my career, the annual allowance taper is the most stupid, the most complicated, the worst thought out and the most likely to alienate the layer of workers we increasingly rely on (given the relentless narrowing of our tax base) to finance our crippling deficit. And that is saying something.

The wider problem of course is that the taper isn’t alone in being a tax that keeps our middling to high earners awake at night. Our entire system is riddled with unnecessary idiocy – usually the result of reactive rather than proactive policy. So the taper is for example the direct result of the failure to figure out how to reform pension tax relief combined with the need to be seen to be making sure “the rich” (who everyone hates these days) don’t benefit from it too much.

A bad policy caused by the lack of a coherent policy. The good news is that now Philip Hammond’s party is riding high. And so he has the rarest of opportunities: he can set out a long-term vision for where the personal tax system should be going, one that equalises taxes paid by the employed and the self-employed, irons out some of the contradictions in pension legislation (even if it means MPs and their own defined benefit pensions suffer), reforms the worst of the VAT system and perhaps even confesses that national insurance is actually income tax. He can then get on with implementing that vision. Frank, for one, will have his fingers firmly crossed.

 This article was first published in the Financial Times

  • rory

    MSW is right, this is ludicrous, however what is more ludicrous is the apparent public assumption that a pension can only be saved for if there is a tax incentive applied. So here is a solution. £40k pa contribution limit, £1m lifetime limit (subject to penalty tax on excess), 20% flat rate tax relief, 25% tax free sum, pension income withdrawals taxed at marginal rate. This would provide a fair and equal incentive for everyone and a decent base-line pension for those that reach the max. If Frank wants more, he can jolly well save for it out of his still very large (top 5%) salary and not expect a nice fat tax dodge.

    • AAJ

      Why have a lifetime limit when you have a pa contribution limit? This just punishes people for investing well.

      There is too much messing around with pensions. The more people feel they can’t trust pensions the more they will invest in something else, or not at all. People can’t make a 40 year decision on something that changes each year.

      No one should pay tax on pension contributions, there should either be an upper limit or a contribution limit. Then there should be a law that makes it illegal for an chancellor to make any more changes.

      • rory

        It no more punishes people for investing well than punishing people with a 40% tax band for earning well. There seems to be a general misconception that somehow money earned in a pension pot is already taxed. Well the contributions aren’t taxed because you get relief and the growth certainly isn’t taxed until it is withdrawn, and there are currently several ways to avoid any tax then. If there wasn’t a lifetime limit it would be entirely possible for a wealthy person paying in £40k pa to build up a £multi-million fortune completely free of tax, whilst everybody else is beavering away paying 20% – 40%. NB. I do think that, in return for a bonfire of tax breaks for high earners, the 45% band should be abolished.

    • Peter Edwards

      I thought the life time limit was how contributions are put in the pot?

    • quark

      Hear, hear. People on high incomes shouldn’t need an incentive to save. I agree 100% with Rory’s sentiments. Higher rate tax relief is both unnecessary, unjust and a waste of taxpayers money.

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