Pensions, with their generous tax benefits, are usually seen as the cornerstone of retirement and financial planning. But as most people are aware, they are complicated and full of rules and regulations. Here, we discuss the pension annual allowance, which has caused many unexpected tax bills recently.
The annual allowance is the maximum amount of pension savings you can have each tax year that benefit from tax relief. You are subject to a tax charge (the annual allowance charge) if your pension savings exceed your available annual allowance for a tax year. The standard annual pension allowance is currently £40,000. Each year you personally can contribute up to 100% of your relevant UK earnings into a pension or the annual allowance (whichever is lower) and receive tax relief.
For most people, relevant UK earnings refer to income received from employment, including your salary, bonuses and commission. The limit on tax relief is 100% of these earnings.
For example, if your UK relevant earnings are £35,000 gross, then you can personally contribute up to a maximum of £28,000 net into your pension (£35,000 minus basic rate tax). If you are a higher-rate taxpayer, you can reclaim higher-rate tax relief via your Self-Assessment tax return.
Even without relevant UK earnings, you can make a pension contribution of £2,880 net and still receive tax relief on it, up to the age of 75.
Employer pension contributions are not restricted in this way, but they need to meet certain conditions in order for the company to claim corporation tax relief on them.
Prevailing tax rates and relief are dependent on your individual circumstances and are subject to change.
The annual allowance for pension savings applies to each pension input period. A pension input period is a measure of time (a tax year) over which contributions have been made to a defined contribution scheme, or a pension has been built up in a defined benefit scheme. These are known as ‘pension savings’ and are measured against the annual allowance to see if there is an excess which will be taxed. Both employee and employer contributions are subject to the annual allowance and any excess is taxed at the employee’s marginal rate.
Under a defined contribution scheme, the annual allowance used is simply the amount of all contributions paid during the pension input period, but under a defined benefit scheme, it is the increase in the value of a member’s rights during the pension input period.
It is extremely complicated to calculate the annual allowance for defined benefit schemes and professional advice is usually required.
Those with an adjusted income of more than £240,000 and a threshold income of more than £200,000 will see their annual allowance reduced by £1 for every £2 of adjusted income they have over £240,000. It can drop down to a minimum of £4,000 once the adjusted income reaches £312,000 or above. This reduction is known as the tapered annual allowance.
When the current tax year’s annual allowance has been used, it may be possible to reduce or completely avoid the annual allowance tax charge by using pension carry forward. This allows you to use any unused pension allowance from the previous three tax years (subject to carry forward rules).
Reasons for breaching the pension annual allowance
Firstly, make sure that you don’t have any unused allowances from the last three tax years that can be carried forward.
Even if your pension carry forward allowances have been exhausted, it may be sensible to continue to accrue the pension and pay the annual allowance tax charge. This is because defined benefit pensions in particular are largely funded by employer contributions, so a percentage of a free benefit is better than no benefit at all. In addition, tax charges can often be paid by the pension scheme, so you do not have to cover the cost of such charges yourself by making an upfront payment out of taxed capital.
Reducing your working hours in order to lower your salary could also be a viable option but should be considered carefully.
Stopping pension payments is usually a last resort, as this will reduce risk benefits such as death in service and ill health retirement benefits. Adequate alternative provisions for these benefits would have to be sought if this were to happen.
If your pension savings made in the tax year are more than your available annual allowance, you should include the excess amount on your Self-Assessment return. This amount is added to your taxable income net of any pension contributions paid by you personally in the tax year, and you will pay Income Tax at your usual rate.
Given the complexities of pension saving calculations, breaching the annual allowance is likely to be unforeseen for defined benefit scheme members. Unfortunately, members are unlikely to be able to forward plan for the payment of a tax charge. In many instances, those affected are not aware of the liability until they receive a pension savings statement from their scheme administrator. As the deadline for issuing a pension savings statement is 6 October following the end of the relevant tax year, if the statement is received close to this deadline, it will leave the member with less than four months to work out if a tax charge is due and if so, how to pay it. In these circumstances, the value of professional financial advice is clear. A financial planner will be able to establish well in advance of the deadline if a tax charge is due.
If you think you are at risk of breaching the annual pension allowance or you just want some further information on how to make the most of all of your tax allowances, we can help. To find out more, book an initial consultation online or call 020 7189 2400.
Issued by Tilney Financial Planning Limited.
Prevailing tax rates and reliefs depend on your individual circumstances and are subject to change.