What to do when you hit the pensions cap

High earners running up against pension caps should do their sums, says David Prosser.

946_MW_P23_Pensions

The BMA fears experienced staff couldleave if pension rulings aren't changed

Should you give up work to avoid a nasty tax bill? This, apparently, is the dilemma now facing doctors in danger of reaching caps on pension-contribution limits. The generosity of the defined-benefit (DB) NHS pension scheme means many are incurring extra tax charges, either as they near retirement, or when they take on overtime and extra work. The British Medical Association (BMA)thinks the problem is so acute we need to change the rules in order to avoid losing crucial frontline staff from the NHS.

However, it's not just high-earning doctors who find themselves in a tricky spot. The annual allowance, limiting the amount of pension contributions you can make each tax year, and the lifetime allowance (LTA), a cap on the total size of your pension fund, apply to all savers. Most people don't get anywhere near them, but if you're a member of a DB scheme, you're more likely to exceed the limits. This is partly because the rules are complex on how contributions and pension rights in such schemes are valued. But DB pensions also offer more valuable benefits than other arrangements.

But are these savers really facing such bleak choices? The BMA argues that once doctors start running into additional tax charges they have no incentive to carry on working.In truth, however, the sums don't stack up in quite this way. The tax charge for those who breach the annual allowance is calculated according to their income, but for most people is likely to work out at between 40% and 45% of the excess. In other words, more than half the cash is still going into their pension. Nor does the charge have to be paid upfront you can usually elect to have your pension scheme pay it, with your benefits reduced accordingly. Similarly, the LTA stipulates a 55% charge on lump-sum withdrawals over the cap (currently £1.055m). No-one wants to pay that much tax, but there's still a benefit remaining.

There are some complications to take into account. In particular, income from overtime is typically non-pensionable, so you don't get extra pension from it, but it does count towards your total income for the year. Since higher earners get a reduced annual allowance, this causes a problem for small numbers of people, though in most cases their additional exposure toan annual allowance charge will be cancelled out by their extra earnings.

Fees cap could be limiting returns

The damaging effect of high fees on your investment returns is well documented. So the government edict that workplace pension funds must not charge more than 0.75% a year (implemented in April 2015) seems eminently sensible.

But there's a problem, says the Association of Investment Companies (AIC), a trade body: fund managers offering exposure to illiquid assets such as private equity and infrastructure have higher costs and are struggling to keep fees under the cap.

As a result, workplace pension scheme members may not get the opportunity to invest in such funds,and therefore could be missing out.

The AIC's warning follows a review of the charges cap announced by ministers earlier this year. The government is eager to persuade pension schemes to invest more in infrastructure, so it's considering relaxing the rules. However, if it does so, pension scheme members will need to think carefully about their fund choices.

It's true, as the AIC says, that some private-equity and infrastructure funds havea record of outperformance this may be worth paying extra for. However, not every fund of this type outperforms, in whichcase the higher fee wouldbe part of a double-whammy effect that depresses your pension-fund returns.

Recommended

Should you defer your pension and stay in work?
Pensions

Should you defer your pension and stay in work?

The pros and cons of deferring your pension and staying in employment beyond 66 are finely balanced.
15 Sep 2021
I wish I knew what a marginal tax rate was, but I’m too embarrassed to ask
Too embarrassed to ask

I wish I knew what a marginal tax rate was, but I’m too embarrassed to ask

Your marginal tax rate is simply the tax rate you pay on each extra pound of income you earn. Here's how that works.
14 Sep 2021
Why the government's plan for funding social care is a lousy one
UK Economy

Why the government's plan for funding social care is a lousy one

Insisting that people use their property wealth to pay for social care is perfectly reasonable, says Merryn Somerset Webb.
10 Sep 2021
State pensioners probably aren’t going to get an 8% pay rise next year
State pensions

State pensioners probably aren’t going to get an 8% pay rise next year

The “triple-lock” could in theory mean an 8% rise in state pensions this year. But that’s not going to happen. Saloni Sardana explains what the triple…
6 Sep 2021

Most Popular

A nightmare 1970s scenario for investors is edging closer
Investment strategy

A nightmare 1970s scenario for investors is edging closer

Inflation need not be a worry unless it is driven by labour market shortages. Unfortunately, writes macroeconomist Philip Pilkington, that’s exactly w…
17 Sep 2021
Two shipping funds to buy for steady income
Investment trusts

Two shipping funds to buy for steady income

Returns from owning ships are volatile, but these two investment trusts are trying to make the sector less risky.
7 Sep 2021
What really causes inflation? Here’s what prices since 1970 tell us
Inflation

What really causes inflation? Here’s what prices since 1970 tell us

As UK inflation hits 3.2%, Dominic Frisby compares the cost of living 50 years ago with that of today, and explains how debt drives prices higher.
15 Sep 2021