UFPLS – planning for unintended consequences
The recent ruling by the Upper Tribunal in favour of HMRC, with respect to tax relief for in-specie contributions, perhaps helps illustrate the complexity of tax legislation and the unintended tax traps your clients could face.
The potential loss of in-specie tax relief, in some scenarios, could increase the overall tax bill for the individual. This would be because they might have to repay tax relief they claimed, and some may have used such a contribution to claw back all, or part, of their personal allowance, as their ‘adjusted net income’ exceeded £100,000. The loss of the relief means an increase in their taxable income in the year in question, and a possible adjustment in their personal allowance.
This ruling got me thinking of other scenarios in which, at first glance, an action might not have any serious repercussions, yet the ‘interconnectivity’ of legislation leads to unexpected tax consequences. In particular, I’ve been thinking of situations where an individual takes an uncrystallised funds pension lump sum (UFPLS).
Presuming the individual satisfies the criteria for the payment of a UFPLS, and the scheme administrator is prepared to pay it, then under the legislation it’s a payment of an authorised lump sum. Where the individual is under the age of 75 it’s tested against their lifetime allowance under a benefit crystallisation event 6. Although it’s classed as a lump sum, the tax treatment of the UFPLS is that normally, 25% is tax free and the other 75% is taxed as pension income, in principle, at the individual’s marginal rate of tax.
However, there are situations, where initially the tax rate is not as described but, is calculated on a month one basis. This applies where the pension provider operates a pay as you earn (PAYE) system and has not previously been notified of the individual’s tax code by HMRC.
This example will put this into practice:
Month 1 tax calculation
In 2019/20 Victoria’s income put her in the HRT bracket. Towards the end of the tax year she took £100,000 from her SIPP in the form of a UFPLS, never having taken any pension benefits previously. Including the tax-free element, she expected to receive £70,000 but only received £67,969. The tax calculation was as follows:
Legislation allows a reclaim of overpaid tax. However, one of the consequences for Victoria of taking the UFPLS is that her adjusted net income then exceeded £100,000, and so she would have lost some, or all, of her personal allowance depending on her individual circumstances. She would also, of course, have triggered the money purchase annual allowance by taking the UFPLS.
Continuing in this vein, taking an UFPLS could also have repercussions for an individual’s annual allowance (AA) in the context of tapering, as detailed in this example:
UFPLS and the tapered AA
Jackie is a member of a defined benefit (DB) scheme with an accrual rate of 1/60th for each year of service (PCLS is by commutation of pension income) and personal contributions set at 11.4% of pensionable salary. She had 17 years of service at the start of the 2020/21 PIP.
In mid-April 2020, she received a promotion with pensionable salary increasing from £130,000 to £150,000. Her employment income matches her pensionable salary and she has no other source of income, though she had a personal pension valued at £100,000. With just a few years left to retirement, and no wish to increase her mortgage to cover the cost of an extension to her home, she decided to take the whole of her personal pension by way of an UFPLS.
As with Victoria’s example, Jackie’s taxable income is increased by the pension income element of the UFPLS, taking her threshold income to £207,900 (£225,000 less her own DB pension contribution of £17,100). With a threshold income in excess of £200,000, we now need to consider Jackie’s adjusted income, which is determined by calculating the employer’s element of the increase in her DB pension rights.
(130,000 x 17/60) x 16 = £589,334
589,334 x 1.017 (uprating by CPI) = £599,353
(150,000 x 18/60) x 16 = £720,000
Pension input amount
720,000 – 599,353 = £120,647
Employer’s deemed contribution for tapering purposes
£120,647 – £17,100 = £103,547
Jackie’s circumstances are such that the AA test is carried out on the default basis. Given her adjusted income exceeds £240,000 (adjusted income is £328,547), the point at which tapering of the AA now kicks in, she would see a reduction in her AA for the 2020/21 year from £40,000 to £4,000. She would then have to consider how much, if any, carry forward of unused AA from the previous three years she had to offset against the chargeable amount of £116,647 (£120,647 – £4,000).
The examples of Victoria and Jackie serve to highlight the complexity of tax legislation and the interaction between different elements. There are many such tax traps in the legislation that can easily catch out the unwary, and that’s why it is imperative for people to seek the appropriate specialist advice.
This article first appeared on Money Marketing