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Compensation

Published  26 January 2024
   5 min read

Can you pay compensation payments into your pension plan and what is the tax position if you do?

General

Compensation payments are usually for receiving wrongful advice. Normally the compensation is paid directly to the affected individual. But sometimes it’s paid to the scheme administrator. The scheme administrator is more likely to claim it when it’s compensation for investment loss, for example a delay in buying units or someone being put into the wrong fund.

What can be done with compensation payments?

Compensation due to the individual can be paid directly to them as a lump sum.  Usually, the individual wants to pay it into their pension plan. The only way this can be done is to pay it as a net personal contribution which is grossed up at the basic rate of income tax.  The individual can claim any additional tax relief in the normal way.  This can cause problems if the individual doesn’t have enough earnings or annual allowance to cover the payment. If that is the case, the only remedy is to stagger the contribution over more than one tax year or only pay contributions up to their tax relief and annual allowance limits.

Compensation due to the pension scheme, for example because of a unit price error being rectified, can be paid directly into the scheme. The scheme administrator will use the money to buy units in the funds the plan is invested in. This means the compensation isn’t regarded as a contribution, so no tax relief is added.

 

Taxation

Any interest element in a payment to the individual will be chargeable to income tax at the individual’s highest rate of tax. But the rest of the compensation is likely to be treated as a capital sum, potentially making it subject to capital gains tax.

However, if the compensation payment is for poor advice, capital gains tax is only payable if the compensation exceeds £500,000 and even then, a claim can be made to HMRC for the amount above the threshold to be exempt.

Disclaimer

The information provided is based on our current understanding of the relevant legislation and regulations and may be subject to alteration as a result of changes in legislation or practice. Also it may not reflect the options available under a specific product which may not be as wide as legislations and regulations allow.

All references to taxation are based on our understanding of current taxation law and practice and may be affected by future changes in legislation and the individual circumstances of the investor.