Sarah Bradford outlines how to make the most of the pensions annual allowance to receive tax relief on pension contributions.
There is no limit on the amount that an individual can contribute to a pension scheme each year. However, there is a cap on the amount of tax-relieved contributions that can be made to a registered pension scheme each year. That cap is provided by the annual allowance. Contributions are also limited by an individual’s earnings.
There is also a second cap – the lifetime allowance – which places a limit on total lifetime pension contributions.
Registered pension schemes
Tax relief is only available on contributions to registered pensions schemes.
A ‘registered pension scheme’ is one that is registered with HMRC and which must, as a condition of registration, meet certain conditions.
Earnings limit
Subject to a person having sufficient annual allowances available, an individual is able to make tax-relieved contributions to a registered pension scheme in a tax year up to the higher of £3,600 and 100% of earnings.
This means contributions of £3,600 (gross) – equivalent to £2,880 net of basic rate of tax. These can be made on behalf of a non-earner (e.g. a spouse).
Annual allowance
The annual allowance limits the amount of tax-relieved pension contributions that can be made to a registered pension scheme each year. The allowance applies to total contributions to registered pension schemes made by the individual or on the individual’s behalf – for example, by the employer. Consequently, in working out the extent to which the annual allowance remains available, employer contributions also need to be taken into account.
The allowance is set at £40,000 for 2018/19. However, it is reduced where an individual has both ‘threshold income’ in excess of £110,000 and ‘adjusted net income’ in excess of £150,000. Unused allowances can be carried forward for up to three years.
Reduced allowance for high earners
The annual allowance is reduced (for 2016/17 and later tax years) by £1 for every £2 by which adjusted net income exceeds £150,000 where the individual also has threshold income of at least £110,000. The reduction cannot generally take the annual allowance below a minimum level of £10,000. The minimum applies where an individual with threshold income of at least £110,000 has adjusted net income of £210,000 or above.
In working out whether the reduction applies, it is important that the right measures of income are used. The concepts are complex and detailed guidance can be found on the Gov.uk website at www.gov.uk/guidance/pension-schemes-work-out-your-tapered-annual-allowance.
The starting point of the calculation is ‘net income’. This is taxable income for the year, less any reliefs that apply. Taxable income will include items such as earnings from employment and/or self-employment, most pension income (including that from the state pension), rental income and investment income, such as dividends and interest. Deductible reliefs may include claims for pension relief where contributions were paid before relief was given, and also certain loss relief claims.
The next step is to work out ‘threshold income’:
- start with ‘net income;’
- deduct the gross amount of pension savings from all schemes where relief has been given at source;
- deduct any lump sum death benefits received from registered schemes; and
- add any salary sacrificed in return for pension provision under a salary sacrifice arrangement or flexible remuneration arrangements entered into on or after 15 July 2015.
If threshold income is less than £110,000, the annual allowance is not reduced, regardless of whether adjusted net income exceeds £150,000. However, if threshold income exceeds £110,000, the next step is to work out adjusted net income.
‘Adjusted net income’ is found as follows:
- start with ‘net income’;
- add tax relief claimed on pension savings where contributions were paid before relief was given;
- add tax-relieved pension contributions (for example, contributions deducted from gross pay);
- add employer pension contributions; and
- deduct any lump sum benefits received from a registered pension scheme.
Non-domiciled individuals must also add back any tax relief claimed on pension contributions made to overseas pensions schemes.
Example 1: Reduced annual allowance
In 2018/19, John has employment income of £125,000 and rental income of £30,000.
John and his employer both pay 10% of his salary into a pension scheme. John’s contributions are deducted from his gross pay, giving relief at source at his marginal rate of tax.
John’s net income is £155,000 (i.e. employment income of £125,000 plus rental income of £30,000).
His threshold income is also £155,000.
His adjusted net income is £180,000 (i.e. net income of £155,000 plus John’s pension contributions of £12,500 and his employer’s contributions of £12,500).
As threshold income is more than £110,000 and adjusted net income is more than £150,000, the annual allowance is reduced.
John is entitled to an annual allowance of £25,000 for 2018/19 (i.e. £40,000 – (50% (£180,000 - £150,000).
Unused allowance
To the extent that the annual allowance is not used in the tax year, unused allowances can be carried for up to three years. Thus (subject to any limitation imposed by the level of the individual’s earnings), the maximum amount of tax-relieved contributions that can be made to a registered pension scheme for a tax year is an amount equal to the annual allowance for that year, plus any unused allowances brought forward.
The current year’s allowance is used first. Where there are unused allowances from earlier years, an earlier year’s allowances are used before those of a later year.
Example 2: Unused relief brought forward
Karen makes pension contributions of £10,000 in 2017/18, 2016/17 and 2015/16. She has unused contributions to carry forward of £30,000 in each of those years.
In 2018/19, depending on her earnings, she can make tax-relieved contributions of up to £130,000 (i.e. her annual allowance of £40,000 for 2018/19, plus amounts brought forward from the previous three tax years of £30,000 per year).
In 2018/19, her earnings are £100,000. She wishes to make a pension contribution of £50,000. This is covered by her annual allowance of 2018/19 of £40,000, with the remaining £10,000 being provided from the £30,000 unused allowances from 2015/16. As the remaining sum of £20,000 from 2015/16 is not used in 2018/19, those allowances are lost.
HMRC have produced an annual allowance calculator, which can be used to check whether a person has sufficient annual allowances available for the tax-relieved contributions that they want to make. The calculator is available on the Gov.uk website (www.tax.service.gov.uk/pension-annual-allowance-calculator).
Annual allowance charge
A tax charge – the annual allowance charge – arises if tax-relieved pension contributions are made in excess of the available annual allowance (including any unused allowance brought forward from earlier years). The charge claws back the tax relief to which the individual was not entitled.
The amount by which the tax-relieved contributions exceed the available annual allowance is treated as taxable income for the tax year and is taxed at the individual’s marginal rate of tax. If the amount of tax is more than £2,000, the individual can ask their pension provider to pay the tax to HMRC from the pension pot.
Money purchase annual allowance
The money purchase annual allowance is a lower annual allowance that applies to those who have flexibly accessed their pension savings and who wish to continue paying contributions. For 2018/19, the money purchase annual allowance (MPAA) is set at £4,000.
The reduced annual allowance was introduced to prevent recycling of contributions.
Lifetime allowance
The lifetime allowance places a cap on tax-relieved pension savings and is the maximum that can be paid out in the form of a lump sum and retirement benefits without triggering additional tax charges. The lifetime allowance is set at £1,030,000 for 2018/19.
If an individual exceeds his or her lifetime allowance, this will trigger a lifetime allowance tax charge. The rate depends on how the money is paid – 55% if it is taken as a lump sum, and 25% if it is taken in another way (e.g. a pension payment or cash withdrawal).
Practical Tip:
Tax relief on pension contributions can be very worthwhile. Contributions up to 100% of earnings (or £3,600, if lower) can benefit from tax relief as long as sufficient annual allowance is available.
