Like many financial advisers, part of my role as Head of Technical is to go deep into technical areas like pensions and taxation. Getting this information wrong can have a large impact on our client’s lives, so it’s important to get it right. But is the line between right and wrong always clear cut?
Is A Limit Really A Limit?
Not every technical limit is as limiting as, say, an ISA contribution. Exceeding some allowances might have tax consequences. But I’d argue that sometimes the tax consequence of exceeding an allowance is preferable to avoiding tax at all costs.
Few people would choose to earn less in order to pay fewer taxes because they end up with less money, but some taxes are less palatable.
Why Exceed A Limit?
I remember doing some work for a client who was likely to exceed their annual allowance due to the generous pension contributions their employer was making. Exceeding the allowance would have resulted in the excess being taxed at their highest income tax rates.
The Tapered Annual Allowance means that these high earners have a lower allowance than most (as little as 10% of the standard allowance for some). In this position, even the standard auto-enrollment compliant contributions could exceed this.
The immediate, emotional response from the client might be to stop the contributions or ask for a reduction down to the limit. While this could be right for some clients, what are they giving up?
If the contributions are from their employer, what alternative might they offer – if any? Accepting the contribution and exceeding the allowance might actually be preferable overall – especially if there is not an attractive financial alternative.
Looking Through A Planning Lens
First, it’s important to address the emotional response. It is a valid feeling and for some a valid approach. It’s okay for your clients not to want to pay what they see as too much tax.
But let’s step back and look at the situation through the planning lens. What is the client’s financial plan? What do they want to achieve (what, when, how much will it cost)? If we have clarity over this we have the best lens for addressing the technical problem.
This client might have had a rapid ascent into their new highly paid position. To maintain her lifestyle in retirement she now needs more money than previously expected. Or she might just have had other priorities, like caring for a relative, with a stronger call on her wallet. Either way, she now needs to build up her retirement funding quickly.
One potentially tax efficient option might be taking advantage of employer contributions. However, if she is fully affected by the Tapered Annual Allowance (all the way down to £4,000), there is a potential problem – having to pay Income Tax at 45% on some of contribution.
If the employer offers no alternative (a take it or leave it scenario), then accepting the contribution and paying the tax may be the best option. 55% of something is better than 100% of nothing, especially if it’s held in the tax efficient environment of a pension.
Some employers may be willing to pay more salary instead of the pension contribution. In this case it is likely that the employer will take into account the additional taxes they have to pay (Class 1 National Insurance at 13.8%) before the employee pays her own Income Tax and National Insurance contributions (c55% total tax loss). What is best for the client in this scenario?
Look back at her goal. She needs to build up a fund fairly rapidly, so maximising the amount deployed for investment seems wise. The impact of taxes if she chooses to receive cash might well leave less money to invest than if she accepted the pension contribution.
It’s only by stepping back and looking at the situation through the lens of the financial plan that we can help clients make great financial decisions.
Dan’s degree Music Technology degree helps him approach Financial Planning problems creatively. He is both a Chartered Financial Planner and a Fellow of the Personal Finance Society (PFS). Dan is an Accredited Paraplanner™ with CISI and is working towards the Certified Financial Planner™ certification. He is head of technical at Paradigm Norton and Chairman of the CISI Paraplanner Interest Group. Having won several awards in his field, Dan continues to work with CISI and other organisations to support others involved in this area of Financial Planning by writing articles, and hosting conferences and events. Outside of the office Dan is married to Hannah and has a young daughter who keeps him on his toes. He is also involved in his local Church in Hatfield. Follow him here.
