This post builds on our existing NHS Pension series. Throughout the post we’ve put links, where relevant, to the appropriate prior material. We do, however, suggest refreshing your understanding of the NHS Pension prior to reading on.
The term allowance reminds me of pocket money, that highly prized one or two pound coin slipped to us for guilt-free spending on sweets or other frivolities. Once it was spent, there was no more. All that remained were jealous glances at the sibling who saved theirs for later, or bought something longer-lasting. Sadly, the adult world doesn’t stop you from spending more than your allowance. It just taxes you for it.
All pensions, NHS included, are subject to two limitations on contributions. Stay within them and your pension money is all yours (until it’s subject to income tax). Breach the allowances, however, and HMRC will come runnin’ to give you even more of a tax bill. These caps are known as the Annual Allowance (AA) and Lifetime Allowance (LTA).
The Annual Allowance
The AA is the total amount you can contribute to pensions in a tax year, not including the State Pension.
It currently stands at £40,000 (or 100% of your earnings, whichever is less). If you put more than this into a pension in a tax year, you’ll breach the AA and the excess is taxed at 40%. And you don’t even get windshield or breakdown cover…
How do you know whether you’re breaching the AA or not? This is less obvious than it would seem. To be clear, the cost of your NHS Pension (e.g. 9.3% of salary) is not contributory towards the AA. You can work out how much of your £40k allowance you’ve used by calculating your ‘pension input amount’. This is best explained with examples, though in essence is the gain in pension from one tax year to the next, multiplied by 16.
Dr. David has been working for the NHS for six years. At the start of the tax year, his pension has accumulated to £5,000. The ‘opening value’ of his pension for the tax year is £5,000 multiplied by 16, then increased by inflation. Assuming inflation is 2%, this is £81,600.
He works another year, earning £54,000. At the end of the tax year, his pensionable amount is now £6,210. The ‘closing value’ of his pension is £6,210, multiplied by 16. This is £99,360.
The difference between the opening and closing values is the pension input amount. I.e. £99,360 minus £81,600. This is £17,760. Dr. David has not breached his AA for the tax year as this is under £40,000.
In the example above, not only has Dr. David avoided any charges for breaching the AA but he also has leftover allowance to use. In theory, he could contribute another £22,240 to a pension and still not be in breach of the AA. That might be through buying more NHS Pension (see here) or paying into a SIPP.
Dr. Denise is a consultant. At the start of the tax year, her pension had accumulated to £48,000. This makes her opening value £783,360. After another year of work, her pension has now accumulated to £52,000. This makes her closing value £832,000. Her pension input amount, the difference between these two, is £48,640. Dr Denise has breached her AA and will be subject to a charge.
There are other facets that muddy the waters somewhat. For example, you can carry unused AA over from the previous three tax years, which may increase your available amount in a given year. Similarly, the inflation number used to modify your opening value is taken from a different year as that used to revalue your pension – this may push you closer to or further from the AA in any given year. The Tapered Annual Allowance, whereby your AA was reduced incrementally if you earned over a certain amount, is less of an issue than previously due to recent changes, though remains worth keeping in mind. As usual there’s a handy NHSBSA factsheet and also information from the Pensions Advisory Service about the AA.
The Lifetime Allowance
The LTA is the total value your pension(s) can have at the time you start to draw money from them, not including the State Pension.
It currently stands at £1,073,100. It is due to rise with inflation, so will be slightly bigger each year. However as your NHS Pension is revalued by inflation + 1.5%, you will eventually hit the LTA if you work long enough. The charge for breaching the LTA is fairly steep: 55% on lump sums and 25% on pension income (in addition to whatever income tax you’d pay on that money).
How can you know whether you’ll breach the LTA or not? The NHS Pension doesn’t have a ‘pot’ to compare against the £1.07m figure. Instead you’ll need to work out the capital value of your NHS Pension. You can calculate your pension’s capital value by multiplying the pension income in retirement you’ll receive by twenty. For example:
Dr. Damian works for the NHS for 40yrs, retiring at 66yrs old. The LTA has risen over those 40yrs (in line with inflation) and is now £2m. His NHS Pension will pay him an annual (pre-tax) income of £110,000. The capital value of his pension is £110,000 x 20 = £2.2m. As such, he has breached the LTA by £200,000. This amount is subject to the charges for exceeding the LTA.
The LTA applies to all your pensions together, not to each individual pension. This is relevant if you contribute to (or have previously contributed to) a pension outside your NHS one:
Dr. Dominique is retiring at 59yrs old. The LTA has risen in line with inflation to £1.2m. Her NHS Pension, after the reduction for early retirement, will give her £50,000/yr in income. She’s also been contributing to a SIPP, which is worth £250,000. The capital value of her NHS Pension is (£50,000 x 20 =) £1m, i.e. under the LTA. However the total value of her pensions includes the SIPP, so is £1.25m. As such, she has breached the LTA and is subject to the charges for exceeding it.
The relationship between your NHS Pension and the LTA is easier to understand conceptually, and to calculate, than the AA. There’s more detail from the NHSBSA for those who want to read deeper into the LTA. Whether you’ll breach the LTA or not is predominantly a product of your pensionable salary and duration of employment. FI(RE) should certainly help in limiting the latter!
What does it all mean Basil?
Those whose salaries climb high enough or work for long enough will almost certainly breach the LTA, and possibly the AA too. Keep these numbers in mind in order to plan a strategy that will minimise tax charges but eke the most value from your pension. Similarly you’ll need to be wary of incurring chargers if you’re planning on also contributing to a SIPP or other pension scheme alongside your NHS Pension. If you can afford it, a reduction in working hours later in your career might be the most rational step forward if you wish to avoid hefty pension bills, even if FI(RE) isn’t part of your plans. Less work? Less tax? Sounds good to us.