Are minimum contributions to workplace pensions and the annual allowance set on a collision course?
For some employers and their employees, the answer to this question could well be yes. The recent increase in minimum contributions to workplace pensions under the automatic enrolment rules could result in a growing number of employees being faced with significant tax charges. In this article we look at why this is the case, and what, if anything, employers can do to help mitigate the tax consequences.
Increased minimum workplace pension contributions
Whether you’re a small, medium or large employer, you’ll be aware that on 6 April 2019 the government’s second planned increase in the minimum contributions payable to workplace pensions was implemented. The new minimum contribution levels from 6 April 2019 are -
|Total minimum pension contribution||Minimum employer pension contribution||Minimum staff pension contribution (if employer pays minimum)|
|8% of qualifying earnings||3% of qualifying earnings||5% of qualifying earnings|
For the 2019/20 tax year, qualifying earnings (the band of earnings that must be pensioned) are between £6,136 and £50,000 a year. This is £512 and £4,167 a month, or £118 and £962 a week.
Example - Jane has basic pay, overtime and bonuses totaling £60,000
Her qualifying earnings are: £50,000 - £6,136 = £43,864
Minimum employer contribution is: £43,864 x 3% = £1,315.92
Minimum total contribution is: £43,864 x 8% = £3,509.12
If Jane’s employer pays the minimum only, she must pay: £3,509.12 - £1,315.92 = £2,193.20 (gross)
Jane has £10,000 of earnings above the £50,000 upper level of qualifying earnings, so no pension contribution needs to be paid in relation to those earnings.
Therefore, where pension contributions are based on qualifying earnings, the minimum contribution can’t be more than £3,509.12 (in the 2019/20 tax year).
How does that amount compare with the annual allowance?
As a recap, the annual allowance is the maximum amount of pension savings that an individual can have each year that benefits from tax relief. For defined contribution (DC) schemes, the amount of new contributions paid by the employee and their employer (or any third party on their behalf) during the tax year is measured against this annual limit. If an employee’s pension savings exceed the annual allowance, they’ll personally face an annual allowance tax charge, levied at their marginal rate of income tax. However, any unused annual allowance from the previous three tax years can normally be carried forward into the current tax year to help avoid a tax charge arising.
The full annual allowance for the 2019/20 tax year is £40,000, but the minimum pension contribution, if contributions are based on qualifying earnings, can’t be more than £3,509.12. You could be forgiven for thinking these two thresholds are a considerable distance apart and can’t possibly cross each other’s paths. For the majority of your employees, that’s likely to be the case for the foreseeable future. But there are some circumstances where an employee’s minimum pension contribution and their annual allowance can, and do, bump into each other.
Reduced annual allowance for certain employees
There are two groups of employees who do not enjoy the full, or ‘standard’, annual allowance –
- Higher earners – For this group, the standard annual allowance for the tax year is reduced by £1 for every £2 by which their adjusted income exceeds £150,000, subject to a maximum reduction of £30,000. This means that a high earning employee’s annual allowance could be as low as £10,000. This restriction, known as the tapered annual allowance (TAA).
- Employees (normally) aged 55 and over who have flexibly accessed DC pension savings – For this group, the amount that can be paid into DC pensions, without incurring a tax charge, is reduced to £4,000 a year. This is known as the money purchase annual allowance (MPAA).
Both of these reduced allowances are still larger than the highest minimum pension contribution of £3,509.12 that we covered earlier. So you may be asking yourself ‘Where’s the problem?’ Well, the answer to that question is that under many pension schemes pension contributions are not based on qualifying earnings. As a result, the contributions are that actually paid for an employee can be significantly more than their available annual allowance.
Alternative definitions used for pensionable earnings
Many employers choose not to base pension contributions on qualifying earnings and, instead, use an alternative definition that typically starts from the first £1 of earnings. The automatic enrolment rules allow for an employer to make use of a certification process, which provides for three possible alternatives to qualifying earnings.
|Alternative quality requirement||From 6 April 2019|
|Set 1 |
|Pensionable earnings must be at least equal to the jobholder’s basic pay.||Total contributions of at least 9% of the jobholder’s pensionable earnings (including an employer contribution of at least 4%).|
|Pensionable earnings must be at least equal to the jobholder’s basic pay, and total pensionable earnings of all relevant jobholders (in aggregate) to whom this set applies must constitute at least 85% of their total earnings.||Total contributions of at least 8% of the jobholder’s pensionable earnings (including an employer contribution of at least 3%).|
|All earnings must be pensionable. ||Total contributions of at least 7% of the jobholder’s earnings (including an employer contribution of at least 3%.|
Under these three alternatives, a high earning employee with, say, a basic salary of £200,000 and a bonus of £30,000 would have total pension contributions of at least £18,000 (Set 1), £15,640 (Set 2), and £16,100 (Set 3). All three of these figures are significantly higher than the minimum TAA and the MPAA. They are also much higher than the highest minimum contribution that would need to be paid if contributions were based on qualifying earnings, £3,509.12.
In this example, an employee with total earnings of £230,000 (before considering any employer pension contributions) would be subject to the minimum TAA of £10,000. If their pension contributions were paid in accordance with Set 1, Set 2 or Set 3, they would personally face an annual allowance tax charge, at their highest rate of income tax (45%), on the contributions in excess of £10,000. So, for example, a tax charge of £3,600 if using the Set 1 basis.
What options are there to mitigate a tax charge?
1. Make use of the carry forward rules
Depending on their contribution and scheme membership history, an employee may be able to carry forward any unused annual allowance from the previous three tax years into the current tax year and so avoid a tax charge arising. The carry forward rules can be used even where the employee is impacted by the TAA, although any unused annual allowance may quickly become exhausted if subject to the TAA for consecutive years.
2. Retain the status quo
Some employees may choose to do nothing. They may wish to continue to benefit from the full pension contribution that is available from their employer, along with making their own required contribution, and take the tax charge hit. They would need to weigh this up against the alternative of a potentially lower reward package if they decided to either leave the scheme or agree to a lower level of contribution.
3. Change the employee’s contribution basis to qualifying earnings
Bearing in mind that a tax charge is only likely to arise where pension contributions are based on one of the alternative definitions of pensionable earnings (Sets 1, 2 or 3), the situation could be avoided altogether by changing to the qualifying earnings basis. The automatic enrolment minimum contribution requirement would still be met, but there would be a reduction in the employee’s total reward package, unless that was compensated in some other way, for example by enhanced salary.
4. Reduce pension contributions
This option needs care. Contributions can only be reduced below the automatic enrolment minimum level if an employee requests this. For example, an employee may decide they can’t afford to pay the contributions they are required to pay to the scheme, so they could either opt to leave the scheme entirely or ask their employer if they can remain a member but on a lower level of contribution. It’s important to remember that employers can’t encourage employees to leave their scheme. Employers can help out here by offering to make up for any reduction in the level of pension contribution in some other way, for example through enhanced salary. Where employer contributions are an entitlement under the employee’s contract of employment, the contract would need to be amended.
Employers rely to a degree on their employees alerting them to the fact that they are affected by either the TAA or MPAA. For some employees it may be obvious, their earnings from their employment may be at such a level that it’s inevitable they will be caught by the TAA.
Although an annual allowance tax charge is a personal tax matter, which an employee is ultimately liable to pay, employers can help out their employees by highlighting the issues with them and having a discussion around possible solutions which they may be able to facilitate. But it’s the employee who has to decide which option is best for them, taking into account their personal circumstances. They may wish to speak to an independent financial adviser or get impartial guidance, such as that available from Pension Wise or The Money Advice Service, before reaching a decision.
The Pensions Technical team, Aegon