Pension saving can deliver valuable tax relief, but breaching a cap can be costly, warns Lindsey Wicks.
Since pensions ‘A’ Day in 2006, we have had two pension allowances to consider: lifetime and annual. Savings within those allowances should benefit from income tax relief. However, it’s not that simple. The annual allowance can be tapered, there is a reduced annual allowance if money purchase savings have been accessed, and whether pension savings will exceed the lifetime allowance in the future is difficult to predict.
The annual allowance
Breaching the annual allowance and suffering a tax charge at marginal income tax rates on the excess is a reality for many pension savers.
Unused allowances can be carried forward for a maximum of three years. If the current year allowance is breached, unused relief from the earliest of the previous three years is used first.
Determining the pension input to test against the annual allowance can be complex. For a money purchase arrangement, it is generally contributions paid by the member or on their behalf (eg, by an employer), including any basic rate tax relief paid to the scheme by HMRC. For a defined benefit scheme, it is generally the increase in the value of the member’s promised benefits over the period.
Example 1
In 2021/22, Ursula has pension inputs of £45,000. In the previous three years, her pension inputs were:
Tax year |
Annual allowance |
Pension inputs |
|---|---|---|
2018/19 |
£40,000 |
£36,000 |
2019/20 |
£40,000 |
£38,000 |
2020/21 |
£40,000 |
£39,000 |
Ursula will not suffer an annual allowance charge in 2021/22 because she can use her £40,000 annual allowance together with unused allowances of £4,000 from 2018/19 and £1,000 from 2019/20.
Ursula will have unused allowances of £1,000 remaining in each of 2019/20 and 2020/21.
A moving target?
The concept of tapering the £40,000 annual allowance for high earners has been around since 2016/17. The income thresholds at which tapering applies were increased from 6 April 2020, but the level to which the allowance is tapered was reduced from £10,000 to £4,000.
The annual allowance is tapered where an individual’s threshold income is more than £200,000 and their adjusted income is more than £240,000. If both conditions are met, the annual allowance is reduced by £1 for every £2 of adjusted income over £240,000. The components of threshold income and adjusted income are:
Threshold income |
Adjusted income |
|---|---|
Net income (from steps 1 and 2, s23, Income Tax 2007 (ITA 2007)) |
Net income (from steps 1 and 2, s23, ITA 2007) |
ADD: Salary sacrifice or flexible remuneration arrangements made after 8 July 2015 where employment income is given up in exchange for the employer making pension contributions |
ADD: Excess relief under a net pay arrangement or pension relief on making a claim |
DEDUCT: Member pension contributions paid using relief at source (the actual contribution plus basic rate relief claimable by the scheme) |
ADD: Member contributions paid via a net pay arrangement or with transitional corresponding relief |
DEDUCT: Lump sum death benefits taxable as pension income |
ADD: Total pension input for the year minus member contributions paid that year |
DEDUCT: Lump sum death benefits taxable as pension income |
As these calculations involve pension contributions themselves, working out the net effect on the annual allowance can be complicated, particularly for defined benefit schemes or where salary sacrifice is in place. There are also anti-avoidance rules to be aware of for arrangements that seek to reduce the adjusted income or threshold income.
Example 2
Bob has a salary of £120,000 and profit from self-employment of £98,000. He contributes 10% of his salary to his employer’s pension scheme under a net pay arrangement, reducing his taxable employment income to £108,000 (the P60 figure).
His employer’s scheme is a career average scheme at an accrual rate of 1/56 per year. His pension entitlement from previous years is £10,000 and this is increased by CPI + 0.5%. Bob also pays £200 per month into a personal pension scheme.
Bob has savings income of £2,000 and dividend income of £1,500.
Bob’s net income is:
£ |
||||
|---|---|---|---|---|
Employment income |
108,000 |
|||
Self-employment income |
98,000 |
|||
Savings income |
2,000 |
|||
Dividend income |
1,500 |
|||
TOTAL |
209,500 |
To calculate Bob’s threshold income, it is necessary to deduct from his net income his £200 per month contributions to his personal pension scheme together with the basic rate tax relief (£50 per month) claimed by the scheme administrator [(£200 + £50) x 12 = £3,000].
Bob’s threshold income is therefore £206,500.
Bob’s adjusted income is made up as follows:
£ |
|
|---|---|
Net income |
209,500 |
Contributions under a net pay arrangement (Bob’s contributions to his employer’s scheme) |
12,000 |
Pension inputs less member contributions (see note) |
23,088 |
TOTAL |
244,588 |
As Bob’s threshold income and adjusted income both exceed the limits, his tapered annual allowance is £37,706 (£40,000 - (£244,588 - £240,000)/2).
Bob may suffer an annual allowance charge as his total pension inputs of £38,088 (see note) exceed his tapered annual allowances of £37,706 unless he has any unused annual allowance from the previous three years.
Note:
To calculate the pension input for Bob’s employer’s scheme, it is necessary to compare the opening and closing values of pension and lump sum rights. It is assumed that CPI is 1.7%.
The opening value is £10,000 x 16 (valuation factor) x 1.017 = £162,720.
The closing pension entitlement is £12,363 (made up of £10,000 increased by CPI + 0.5% (£10,220) plus the new benefit accrual of £2,143 (1/56 x £120,000)).
The closing value is 16 x £12,363 = £197,808.
The pension input amount for Bob’s employer’s scheme is £35,088 (£197,808 - £162,720).
Bob’s total pension inputs minus member contributions are as follows:
£ |
|
|---|---|
Personal pension (pension input) |
3,000 |
Employer’s scheme (pension input) |
35,088 |
Total pension inputs |
38,088 |
Member contributions (£3,000 + £12,000) |
(15,000) |
Pension inputs minus member contributions |
23,088 |
Salary increases can trigger significant jumps in benefit accruals for defined benefit schemes. However, discretionary bonuses and other taxable awards such as one-off share payments could create an issue for defined contribution schemes – particularly if these amounts are pensionable. As well as causing a one-off income windfall for a particular year (that could give rise to a tapered allowance), they could also produce a spike in pension inputs. Also, look out for cash cancellations of share-based awards that sometimes happen on M&A transactions.
Should a member crystalise some of their money purchase benefits, they will have a reduced money purchase annual allowance of £4,000.
The lifetime allowance
If the lifetime allowance is exceeded, the excess is subject to a tax charge: 55% if the excess is withdrawn from the scheme as a lump sum, and 25% if it is retained in the scheme, transferred to a qualifying overseas pension scheme or paid as income. If taken as income, the 25% tax charge is levied before applying the income tax charge.
The current lifetime allowance limit of £1,073,100 will remain in place until 5 April 2026. Pension benefits are measured against this limit whenever there is a benefit crystallisation event (there are 13 such events). This could be when a pension is taken, but ‘doing nothing’ is not a get out as reaching the age of 75 with unused funds is also an event.
It can be difficult to predict future values and whether the limit might be breached. It has been possible to protect funds in the past when:
- the rules were introduced in 2006 (primary protection or enhanced protection); and
- the lifetime limit has been reduced (fixed protection and/or individual protection).
Individuals with primary, enhanced, or fixed protection must take care not to make any further contributions. This could happen inadvertently if they change jobs and are auto-enrolled in a scheme. Under auto-enrolment, employees can opt out within a statutory window and maintain their protection. Employers also have to re-enrol employees after a three-year period of opting out. However, where an employer has reasonable grounds to believe that the employee has enhanced protection or fixed protection (for example, has been given a copy of an HMRC certificate), they are not required to auto-enrol or re-enrol that employee.
One-off pension contributions may also be suggested as part of other tax planning. However, that is not appropriate where certain lifetime allowance protections are in place.
About the author
Lindsey Wicks, Technical Editor, Tax Faculty