Our step-by-step guide to calculating the potential tax charges for defined benefit schemes following Treasury changes to the annual allowance.
The government today confirmed it will cut the annual allowance from £255,000 to £50,000 and the lifetime limit from £1.8m to £1.5m.
Additionally, it has increased the factor for valuing final salary benefits from 10 to 16.
But how do you calculate the tax charge?
We use the example of a member who has been a member of a 1/60th final salary scheme for 34 years and gets a 20% pay increase from £60,000 to £72,000.
Such a member would see her tax liability calculated as follows.
First the opening pension entitlement is calculated as £34,000 (34/60 of £60,000).
Next the opening annual pension entitlement is revalued. If the individual had stopped accruing pension after 34 years, then the pension would have been uprated by the CPI. If the CPI increase is assumed to be 2.5%, then her pension earned after 34 years would have risen from £34,000 to £34,850.
The closing pension entitlement is then calculated. If pension accrual instead continues, then her pension will rise to £42,000 (= 35/60 x £72,000) as a result of the extra year's service and the pay rise in the 35th year.
The increase in annual pension entitlement is therefore £7,150.
This is then multiplied by the new annual allowance factor of 16 to give a deemed contribution of £114,400 - £64,400 in excess of the annual allowance.
Once deemed, the contribution can be tested against the individual's annual allowance, taking account of unused allowance from the previous three years, and any charge due can be determined.
If this particular individual had received increases in pay of 5% per annum in her 32nd, 33rd and 34th years then her allowance in each of these three earlier years was £50,000, but her contributions over those three years totalled only £80,600 (£25,200 + £26,800 + £28,600).
She therefore has unused allowance from these earlier years of around £69,400 (= 3 x £50,000 - £80,600) available to carry forward - and therefore has an effective annual allowance in her 35th year of £119,400 - sufficient to cover the deemed contribution in that year of £114,400 and still leave £5,000 to carry-forward to future years.
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