Can you pay compensation payments into your pension plan and what is the tax position if you do?
Compensation payments are usually for receiving wrongful advice. Normally the compensation is paid to the member 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?
If compensation payments are paid to the scheme administrator who then uses the money to buy units in the funds the plan is invested in, they aren’t regarded as contributions and so no tax relief is added.
Compensation due to the individual can be paid directly to them as a lump sum. Usually the member wants it paid into their pension plan. The only way this can be done is to pay it as a net member contribution which will be grossed up at the basic rate of income tax. The member can also claim any higher rate tax relief due 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 pay the compensation to the individual who can then 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 as a gross amount.
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, CGT 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 also to be exempt.
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.