Annual Allowance warning: taking early retirement could land you with a huge tax bill

Hundreds of public sector workers face demands from the taxman if they have to retire early.

While giving up work early in order to enjoy retirement may be the dream for many people, for others there is little choice in the matter.

Each year thousands of people up and down the country are forced to retire earlier than expected due to ill health. 

This can have a big impact on your finances in a host of ways of course ‒ chances are you’ll have to find ways to manage your bills on a lower income.

And what’s more, new research has suggested that some people in this position are liable to be whacked with a significant tax bill.

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An overnight boost

Different pension schemes will treat ill health in a variety of different ways.

Depending on the terms of your scheme, you may be able to take your pension early, so that the funds are at your disposal from when you have to retire.

Some pension schemes go a little further, essentially treating it as if you continued working from the day of your early retirement up to your actual retirement age.

The additional pension cash you’d have accrued over this period is then added to your pot, in one single payment.

And that’s where trouble can arise.

Watch out for the Annual Allowance

It’s not exactly breaking news that pensions can get a little complicated. And one of the many areas where it’s important to keep up to date with what’s allowed and what isn’t is the Annual Allowance.

For once when it comes to money, the name tells the story ‒ this is how much you’re allowed to save into your pension in a single tax year and still receive tax relief.

Importantly, this limit applies across all of your pensions collectively. It’s not like there’s an individual limit that you can get around by simply opening a new pension plan with another provider.

Currently, the Annual Allowance stands at £40,000, which sounds a huge amount.

But if you happen to have a generous pension scheme, and fall ill with a fair few years before you were due to retire, it can be relatively simple for your pension pot to receive a lump sum that puts you beyond that figure.

No tax relief is paid on any contributions above the allowance, while you’ll also face an Annual Allowance charge. This is calculated by adding the excess to the top part of your taxable income, in order to work out what Income Tax band to charge you ‒ so 20% for Basic Rate taxpayers, 40% for higher earners, and 45% for Additional Rate taxpayers.

Importantly, the excess isn’t actually treated as income itself, so it won’t have implications for things like your personal allowance or whether you need to start paying back some of your child benefit.

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Tapering the allowance

It’s also worth remembering that the pensions Annual Allowance is reduced for high earners.

For every £2 you earn over £150,000, the allowance is lowered by £1, down to a minimum of £10,000.

Does this really happen?

Obviously, plenty of us are not on such generous pension schemes, so it can be easy to assume this doesn’t really happen in practice.

But that isn’t the case, as a new Freedom of Information (FOI) request from pension provider Royal London has revealed.

It contacted the Greater Manchester Pension Fund, a large Local Government pension provider, to establish the details of how it handles ill-health early retirement ‒ and whether this ever lands recipients with a large tax bill.

If savers are ill enough that they qualify for ill-health early retirement, but not so severely ill that it’s impossible they will ever work again, then the growth in their pension pot will be tested against the Annual Allowance.

And the FOI revealed that in 2018/19 alone 10 members of the scheme were contacted to say that their pension growth had taken them above the allowance, with six of these subject to a tax charge.

As Royal London pointed out, if there is a similar rate seen across all public sector pension schemes, then there are hundreds of savers across the country each year who face a hefty tax bill as a result of the way their scheme handles ill health.

Sir Steve Webb, policy director at the firm and a former pensions minister, said it was “very harsh” to punish those who are in poor health with big tax bills.

He added: “It is not the case that the workers who face these bills have been shovelling money into a pension in order to max out on pension tax relief. 

They have simply found themselves unable to do their job, often through no fault of their own, and it is quite wrong to saddle them with a large tax bill as a result.”

He’s absolutely right. These people aren’t actively choosing to access their pension in a particular way, or attempting to play the system. They have simply got sick, and are being punished by the tax system as a result, which is utterly perverse.

It’s no secret that there are serious problems with the way that pension allowances work already, with the British Medical Association blaming the tapered Annual Allowance for increases in doctors choosing to cut their hours and retire early.

The Government has even acknowledged that there is an issue there which it wants to review. It should ensure that the current unfair way it treats those forced to retire due to their health is included in that review, rather than focusing solely on retaining high earning doctors.