More than 100,000 pension savers are at risk of enormous tax bills, through no fault of their own.
The problem stems from changes the Government has made to the Lifetime Allowance for pension tax relief over the last couple of years.
The amount that people can put into their pension pots and still enjoy tax relief on their contributions has been slashed in stages from £1.8 million down to just £1 million.
While this would apply to all savers with such healthy pots, those who already had a significant amount set aside could essentially 'lock in' the higher limits through schemes called ‘Individual Protection’ and ‘Fixed Protection’.
This was obviously a smart thing to do, as it would ensure they were not impacted by the drastic slashing of the lifetime allowance.
However, one of the conditions for the ‘Fixed Protection’ scheme was that the saver could not accrue any further benefits in future.
And that could lead to issues.
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Eliminating inequalities
The Government used to run a second State Pension scheme, which was known as SERPS.
The idea was that you paid national insurance contributions based on your income, and that money went towards a second form of State Pension, this time tied to your earnings.
However, while they aren’t that common anymore, in decades past plenty of employers offered defined benefit pensions, which rewarded employees with a percentage of their annual salary as a retirement income.
And if you were on a defined benefit pension, you could ‘contract out’ of the SERPS scheme. In order to do this though, your alternative scheme had to offer a guaranteed minimum pension (GMP).
This is exactly what it sounds like, a minimum amount that you have to be paid in retirement.
Last year the high court heard a case around GMPs, and ruled that pension funds had to eliminate any gender differences around them.
In other words, men and women should receive the same.
While this may only mean a small difference in the income of a saver entitled to a GMP, it could be classed as a benefit.
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What difference will this make?
If the move to equalise guaranteed minimum pensions is classed as the accruing of a benefit – and therefore invalidates the protection – then a freedom of information (FOI) request from Royal London suggests that more than 100,000 pension savers may be impacted by this.
And that impact is enormous. If a saver’s tax relief limit dropped from £1.8 million to £1.03 million, as it currently stands, then Royal London reckons their tax charge on the difference would jump to a whopping £423,500.
That’s one hell of a punishment for having diligently saved over a working life, and having been proactive enough to protect that pension using a scheme from the Government itself.
And while you might think that virtually no-one has such a large pension pot in place, the figures from the FOI request show that actually there are lots of savers with a substantial pension pot who are at risk.
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Averting catastrophe
Steve Webb, director of policy at Royal London – and a former pensions minister – noted that the issue combines two of the more complex areas of pensions, but that combination could result in a “catastrophic tax bill” for someone who has acted entirely in good faith.
The trouble is that while both the taxman and the Department for Work & Pensions (DWP) are well aware of the issue, there is little sign that they plan to actually do anything about it.
For example, in its consultation paper on benefit simplification for defined benefit pensions published at the end of last year, the DWP simply said that it would continue to “investigate whether changes might be necessary to tax legislation”, while HMRC has said it is still considering the issue and may publish guidance if necessary.
It’s not good enough for them to take such a blase attitude towards an issue that could leave responsible savers massively out of pocket.
And while this will not impact most of us, it’s still more than 100,000 savers who are now in a concerning situation and receiving little support from the authorities.
This needs to be addressed and soon. Leaving savers in limbo cannot be an option.
In the meantime, have a look at what you can do to best minimise your tax bill when accessing your pension funds.