Not many investments give you an immediate, guaranteed return of between 25% and nearly 82% just for paying in money. But with the Government’s tax relief, that’s exactly what happens when you make a pension contribution.
The one caveat is that these generous rules only apply to contributions up to your annual allowance. And unfortunately, it’s not always easy to work out how much yours could be.
In this article we explore some of the nuances of the pension annual allowance in more detail. We will find out why the allowance is significantly lower for certain people, how you may be able to pay extra into your pension and why it’s so important to get expert help with your pension.
Put simply, if you are a UK resident you can usually pay as much money as you earn into your pension each year, up to a maximum of £40,000. There is nothing to stop you contributing more than this, although the Government won’t add any tax relief and you will also pay a tax penalty at your marginal rate on any contributions made by your employer or someone else that exceed the allowance.
When measuring your pension against the allowance, the Government takes into account all contributions from you, your employer and any other person (such as a friend or relative). If you have a defined benefit or final salary pension, the Government looks at the increase to your member’s rights over the tax year.
Up to £2,880 can be paid into pensions for children and anyone else that doesn’t have earnings above this amount. After 20% basic-rate tax relief has been applied, this annual contribution becomes £3,600.
As pension contributions can be made by other people, many parents and other relatives choose to set up pensions for the children in their lives to take advantage of this allowance.
There is also a lower annual allowance for anyone who has started taking income from their pension. This is called the Money Purchase Annual Allowance and it is currently £4,000.
The allowance applies if you have made a lump sum withdrawal from your pension over and above the tax-free cash allowance or started to take an income through income drawdown, but not if you have used all or part of your pension to buy an annuity.
April 2016 saw the introduction of the tapered annual allowance – a new, reduced allowance for higher earners. The allowance falls by £1 for every £2 of ‘adjusted’ income received over £150,000, from £40,000 down to a minimum of £10,000 for those with more than £210,000 of income.
However, to make things more confusing, the allowance won’t apply if you have less than £110,000 of ‘threshold’ income. Broadly speaking, the differences between the two are:
Understandably this has left many higher earners scratching their heads when it comes to calculating their annual allowance. Often, the help of a financial planner is needed.
It is possible to make pension contributions above the annual allowance through pension carry forward. This involves using any unused allowance from the last three tax years.
You must use all of your current annual allowance first, and you will need to have had a pension in each of the three previous years. But you don’t need to have made any contributions and your new contributions do not have to be made into the same pension.
Your pension contributions are still limited by the amount that you earn in the current year, but carry forward could be a good idea if you earn more than £40,000 – especially if you are affected by the tapered annual allowance.
Business owners are able to make pension contributions through their company to take advantage of employer contribution rules. Unlike personal contributions, employer contributions are not restricted by your annual earnings. This can be beneficial for business owners who take most of their income through dividends rather than a salary, and therefore are only able to make small personal contributions (as dividends aren’t included when calculating annual earnings).
However, employer contributions do count towards your annual allowance – although you can still take advantage of carry forward to potentially pay up to £120,000 extra into your pension this year.
There are benefits for the company too. Unlike a salary, there is no National Insurance to pay on pension contributions. They can also be treated as an allowable business expense and offset against a corporation tax bill. However, for this to apply HMRC must be satisfied that the contribution is ‘wholly and exclusively’ for the purposes of the employer’s business.
This can be a particularly complex area, so if you are a business owner you should speak to a financial planner about making the most of pension contributions.
With so many different rules and exceptions, it is no wonder that a lot of people are left in a quandary when it comes to their pension allowances. This is why it is important to speak to an expert if you want to make the most of your pension contributions (and the generous Government tax relief that comes with them).
For more information about your pension allowances please speak to your usual Tilney contact. If you are new to Tilney, please call us on 020 7189 2400, email firstname.lastname@example.org or book a no-obligation consultation with our financial planners.