Understanding scheme pays

7 months ago

HMRC’s September bulletin revealed that, once again, the number of people exceeding the annual allowance is increasing. In the 2019/20 tax year, 42,350 taxpayers exceeded the annual allowance, up from 34,260 in 2018/19. The value of excess contributions also rose; in 2019/20, they totalled £950 million, an increase of £130 million on 2018/19.

The annual allowance has been set at £40,000 since the 2014/15 tax year, disregarding carry forward, and can be reduced further by the tapered and money purchase annual allowances. When contributions exceed a member’s allowance, an annual allowance tax charge arises, effectively limiting the amount they can save tax-efficiently into their pension.

There are two ways to pay the charge: either personally via self-assessment, or by using a process called ‘scheme pays’ where (as the name suggests) the charge is paid direct to HMRC from the pension scheme. With more people impacted than ever, it’s important to understand how the annual allowance charge is calculated and when scheme pays could help members meet their liabilities.

Calculating the charge

The annual allowance tax charge aims to reclaim the tax relief on excess contributions. To achieve this, the charge is calculated by adding the excess contribution to the member’s taxable income for the tax year, and the corresponding rate of tax is applied. More than one rate of tax may apply, and Scottish taxpayers may be subject to different rates than the rest of the UK.

Members should therefore make sure to claim all the tax relief they’re entitled to, even if they’ve exceeded the annual allowance.

Paying the charge

Members may choose to pay the charge personally, via scheme pays (if certain conditions are met), or by using a combination of the two. But in all cases, the member must inform HMRC of the charge in their tax return.

The self-assessment tax return can be amended up to one year after filing. If a member needs to amend an older return, they’ll need to write to HMRC, which will issue an updated tax bill.

Paying the charge personally is perhaps the most straightforward option, but it may be challenging for the member to come up with the funds, so scheme pays can be appealing.

Scheme pays

Scheme pays requires a scheme administrator to settle the charge from the member’s pension and makes them jointly liable for ensuring it is paid. Two conditions must be met to qualify for scheme pays:

  • the charge must be at least £2,000; and
  • contributions to the scheme that tax year must exceed the £40,000 annual allowance.

To use scheme pays, the member must notify the scheme by 31 July in the year following the year in which the tax year to which the annual allowance charge relates ended.

For example, if the charge relates to the 2021/22 tax year, the member must notify the scheme administrator by 31 July 2023.

They can’t notify their scheme before the tax year the charge relates to has ended, unless they intend to fully access their pension or are approaching age 75 with either unaccessed funds or funds in drawdown. In this case, they must notify the scheme before either event occurs.

Where scheme pays is used, the scheme administrator must adjust the member’s benefits on a “just and reasonable” basis to reflect the charge paid. For money purchase schemes, this is a straightforward deduction of the amount paid, but for defined benefits schemes, an actuarial calculation is needed. This is typically confirmed in the scheme’s standard documentation.

Voluntary scheme pays

Where the conditions for scheme pays aren’t met, schemes can still pay the charge from the member’s pension but on a voluntary basis. Schemes don’t have to offer this option, but it allows for greater flexibility, allowing the scheme to pay the charge where only the tapered or money purchase annual allowance has been exceeded, or where the charge arose due to contributions under another scheme.

This may give the member the freedom to choose whether the charge is paid from a money purchase or defined benefits scheme. Paying the charge from a money purchase scheme means the long-term growth on those funds is lost, but deduction from a defined benefits scheme means giving up future guaranteed income, which the member may value highly.

The scheme doesn’t become jointly liable when the payment is made on a voluntary basis. This means that if the charge isn’t paid by the member’s self-assessment deadline, they may incur late payment penalties from HMRC.

Importantly, schemes pay the charge in their quarterly HMRC returns. Whilst there’s no strict deadline for asking a scheme to make a voluntary payment, in practice the scheme needs to account for the charge in quarter three (ending 30 September) to make the payment before the member’s self-assessment deadline. If the deadline will be missed, it may be preferable for the member to pay the charge personally.

This article was previously published by Professional Paraplanner

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Bethany Joslyn

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Technical Consultant

Beth joined AJ Bell in 2013 and has over ten years’ experience in the financial services industry. She has previously worked in Client Services and Customer Relations, and joined the Technical Team in 2019. Beth provides technical support to various teams within the business and is involved in designing and delivering technical training to staff. In 2021 she completed the CII Diploma in Financial Planning.

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