The annual allowance tax charge and the 'scheme pays' option

The essential principle of the annual allowance is to limit the amount of “tax privileged” pension savings someone can accrue each tax year (I cover the basic rules relating to the annual allowance in a separate article). The limit applies to all pension savings, including those made by the individual themselves, their employer, or any other third party. However, the annual allowance is not a restriction on the amount of tax relief given as and when the savings are made – it works by applying a tax charge when the allowance is exceeded.

A client’s annual allowance will depend on certain factors. It will be a very personal figure as it’s based on the individual’s current year annual allowance plus the value of any unused allowances carried forward from the previous three tax years. It’s also important to factor in the effect of any tapering that may apply to the client and, where applicable, to consider any contributions that need to be measured against the money purchase annual allowance.

If the total value of pension savings in a given tax year exceed the client’s annual allowance (including any carry forward) or, where applicable, the money purchase annual allowance, then a tax charge will be calculated on the excess amount for the tax year in question.

Broadly speaking, the charge is be calculated by “notionally” adding the excess contribution amounts to the client’s taxable income for the year and is charged at their marginal rate of Income Tax (or rates if a tax threshold is crossed). The annual allowance excess will not, however, have any effect on reducing or removing the client's personal Income Tax allowance.

The client is always personally liable for this tax, regardless of whether the contributions were made by the individual, their employer, or someone else. They may have to – or want to – pay this directly to HMRC. In some cases, though, it may be possible to pay the charge from the client’s pension savings. This option is known as “scheme pays”. All pension schemes must facilitate the payment of the tax charge when requested to if certain conditions are met. This is known as “mandatory scheme pays”.

Mandatory scheme pays

Where the mandatory scheme pays conditions are met, the pension scheme will become jointly and severally liable with the client for all or some of the tax charge and must fulfil requests to pay the charge from the client’s pension savings.

1. The first condition is that the individual’s total annual allowance tax charge is over £2,000. 
2. The second condition is that the client has exceeded the standard annual allowance for the pension scheme in the same tax year. For the purpose of this second condition, the tapered annual allowance and money purchase annual allowance are ignored. Essentially, this means the total value of pension savings contributed to the scheme must have exceeded £40,000. 

Where these conditions are met, there is no minimum sum that the client can ask the scheme to pay. However, if it’s less than £2,000, then they need to confirm to the scheme that their total annual allowance tax charge liability is greater than £2,000. The maximum amount the client can ask the scheme to pay is the tax charge that applies to any pension savings contributed to that scheme which exceed the standard annual allowance.

The deadline for mandatory scheme payment requests is 31 July in the year following the tax year when the charge became due. So, for example, if a client exceeds the standard annual allowance in the 2022/23 tax year, the request needs to be received by the pension provider by 31 July 2024.

Voluntary scheme pays

An alternative to “mandatory scheme pays” is “voluntary scheme pays”. Any pension scheme can offer voluntary scheme payments, although many do not. Where a scheme does offer this facility (such as the Fidelity Pension), there are no minimums and the scheme can pay any annual allowance tax charge even if it does not relate to pension savings contributed to that arrangement. As the payment is voluntary, it’s for the scheme to decide their criteria for acceptance.

Where voluntary scheme pays is offered, the scheme will never become jointly and severally liable for the charge. It remains the sole liability of the client. As such, the reporting and payment deadlines for voluntary payments are different to mandatory payments.

With voluntary scheme payments, the tax charge needs to be settled by the deadline for personal tax. This is 31 January following the end of the tax year. Please note this is the deadline for the payment to be received by HMRC and the deadline for instruction to the provider is likely to be much sooner than this. This is due to the fact that pension providers account for tax with HMRC quarterly, with any tax settlements following up to 45 days after the end of each quarter. At Fidelity, for example, any voluntary scheme payment requests need to be submitted to us by 31 August following the end of the tax year.

Notifying HMRC

Finally, whenever the annual allowance or money purchase annual allowance has been exceeded, the client needs to notify HMRC. This should either be through the individual’s self-assessment return or they can contact HMRC directly. This notification should include details of any scheme payments that have been made, or are going to be made, by the pension provider.