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The annual allowance for pensions

Ever heard the slogan: Tax doesn’t have to be taxing? I’m guessing whoever came up with it never had to deal with the annual allowance for pensions savings.

Oh, and don’t get me started (yet…) on its ghastlier sister, the tapered annual allowance.

These finickity pension rules are enough to make even hardened tax accountants sigh into their calculators.

But let’s be brave and together try to get through this guide to the annual allowance.

What is the annual allowance and why does it exist?

The annual allowance for pensions savings for 2019/20 is £40,000. This means that if your total contributions into your pensions during the current financial year are greater than £40,000 then you must pay a tax charge.

This tax charge is an individual’s top marginal income tax rate (for example 40% for a higher-rate tax payer) on the amount that’s contributed to a pension that’s above the annual allowance.

When you put money into a pension, the Government provides you with tax relief. The underlying principle behind this pension tax relief system is that you defer taxes. You get back the tax you paid today in your pension, but you will later pay tax when you take the money out as income.1 [1]

With the annual allowance, the Government is basically capping the amount of tax relief it will give you in a year. In effect, it is saying: “You’ve got enough from us this year, you’re on your own now”.

This may strike you as quite reasonable in principle. Why should the Government subsidize the pension savings of the ‘metropolitan elite’?

And in general I agree. But there are some issues.

Firstly, people don’t earn a consistent salary over their career. They are likely to earn more in later years – and at that point they’ll want to contribute much more to their pensions.

Secondly, lots of government tinkering has resulted in some unintended consequences. These unintended consequences appear to undermine the spirit of what the introduction of the annual allowance was meant to achieve. More on that later.

Tax relief

Let’s quickly touch on the tax relief rules and how they work.

Currently, tax relief on gross individual pension contributions is limited to £3,600, or 100% of relevant UK earnings per tax year. The annual allowance sets the upper limit on the amount of pension contributions on which you receive tax relief.

There are two types of pensions tax relief:

Importantly, there is no carry forward of unused tax relief.

Annual allowance

The annual allowance is based on ‘pension input amounts’ – that is, the total of all your pension contributions.

The annual allowance can be carried forward.

The annual allowance varies depending on how much you earn and whether or not you have taken some pension benefits.

Mayday A-Day

The annual allowance came into existence on 6 April 2006. This date is known to those in the pensions industry as ‘A-Day’.

A-Day is the pension expert’s equivalent to the birth of Christ. Everything in pension land is now dated as pre-A Day or post-A Day.

Prior to A-Day there were a bunch of rules and limits as to how much could be contributed to an individual’s pension. It was all very convoluted and messy.

A-Day cleaned the place up – sort of.

The annual allowance was initially set at £215,000. In 2010/11 it was lifted up to £255,000. Then in 2011/12 it was dramatically slashed down to £50,000. Finally, a further cut in 2014/15 gave us today’s £40,000.

[2]

A highly boring technical addendum: You’ll notice some asterisks by some of the figures in the chart above. Due to the dramatic change in the annual allowance in 2011/12, a one-off pension ‘straddling’ adjustment was available. We won’t delve into the detail, but if 2011/12 is relevant for your annual allowance, remember that there were some special rules that applied. In 2015/16 the Government aligned pension input periods to tax years. Before then, pension input periods and tax years were not necessarily aligned. The Government adjusted the annual allowances so that for the period 6 April 2015 to 8 July 2015 the annual allowance was £80,000, while for the period 8 July 2015 to 5 April 2016 the annual allowance was zero. But you could carry forward the lower of £40,000 and £80,000 less what you input between pre-8 July; minus what you input post 8 July. In effect, you could get up to £80,000 in annual allowance. We’re pretty sure they do this kind of thing just to win bets with co-workers.

With the introduction of pension freedoms [3] in 2015, a money purchase annual allowance was introduced to further limit the amount of tax-relief available for those who have accessed some of their pensions.

In 2015/16 and 2016/17 the money purchase annual allowance was £10,000. In 2017/18 it was reduced to £4,000.

Finally in 2016/17 the Government introduced the tapered annual allowance, potentially reducing an individual’s allowance to a minimum of just £10,000. (Again, more on that later).

How the annual allowance works

The annual allowance is assessed each tax year (unlike the lifetime allowance [4], which is assessed at certain points of time when you interact with your pension).

Inputs

The first step is to calculate your total pension contributions in the relevant pension input period.

For defined contribution pensions this is straightforward:

[5]

For defined benefit pensions it’s a little bit more complicated:2 [6]

[7]To calculate the ‘value’ of a defined benefit pension you take the total amount of annual pension built up at the start and end of the year and multiply by a factor of 16.3 [8]

It’s easier to see with an example:

Tina is a member of a final salary scheme giving her a pension of 1/60th pensionable pay for each year of service.

At the start of the pension input period Tina’s pensionable pay is £80,000 and she has 31 years pensionable service.

At the end of the pension input period Tina’s pensionable pay has risen by 5 per cent to £84,000 with 32 years pensionable service. Tina does not have any other pension arrangement.

Step 1: Calculate opening value

Annual Pension: 31/60 x £80,000 = £41,333.33
Multiply by factor of 16: £41,333.33 x 16 = £661,333.28
Increase by CPI (say 3%): £661,333.28 x 1.03 = £681,173.27

Step 2: Calculate closing value

Annual pension: 32/60 x £84,000 = £44,800
Multiply by factor of 16: £44,800 x 16 = £716,800

Step 3: Calculate pension input amount

Closing value – opening value = £716,800 – £681,173.27 = £35,626.73.

Tina is within the annual allowance and there is no charge.

Carry forward

Unused annual allowance from pension input periods that ended in the previous three tax years can be carried forward and added to the annual allowance for the current pension input period.4 [9]

You don’t need to make a claim to HMRC to use carry forward, but keep a note if you do – just in case.

The annual allowance charge

As we warned earlier, a charge is levied on the excess of pension contributions above the annual allowance.

For example, if an individual has a total of £50,000 contributed to their pension in a year and they have no carry forward, the excess of £10,0005 [10] will be liable to a charge.

The charge is applied at the individual’s marginal rate. In effect, it sits on top of an individual’s taxable income.

For example, for a higher-rate taxpayer the tax charge on an excess pension contribution of £10,000 is £4,000 (£10,000 x 40%).

If you’ve exceeded the annual allowance you’ll need to record this in a self-assessment tax return. When doing your tax return there’s a specific box to fill in if you’ve contributed in excess of the annual allowance.

It’s possible to get your pension scheme to pay the charge for you, under the ‘scheme pays’ system. This is available if:

The total annual allowance charge is over £2,000, and

The inputs are in excess of the standard annual allowance in the scheme.

Pension schemes must provide the information you need for calculating your pension inputs automatically each year. But don’t rely on your various schemes, it’s up to you. If necessary, contact your pension provider to get the information you need.

The tapered annual allowance

No doubt the bit you’ve been (eagerly) waiting for. In 2016/17 the Government introduced the tapered annual allowance. Aimed at high earners, this tapering sees the annual allowance reduced for people who have ‘adjusted income’ over £150,000 and ‘threshold income’ over £110,000 a year.

The tapered annual allowance reduces by £1 for every £2 over £150,000 down to a minimum of £10,000.

Both adjusted income and threshold income need to be above the limits for the tapering to come into effect. If you are over only one of the limits, the taper doesn’t apply.

Calculating adjusted and threshold income

[11]

Both adjusted and threshold income include all taxable income. The difference between the two can be summarised as:

Unintended consequences

Unfortunately, there have been many unintended consequences with the tapered annual allowance.

Most prominently it has snared doctors in a pensions tax trap [12], with many doctors landed with five-figure tax bills.

But more importantly, it’s just plain stupid policy. The tapered annual allowance is fiendishly complicated to apply because it relies upon predicting future total income and pension contributions before they become known.

In some cases, people who contribute in excess of £40,000 can face a marginal tax rate of over 100% – that is, they are actually worse off if their salary increased!

For instance, an individual may earn above the adjusted income but below the threshold income meaning the taper doesn’t apply. But then a small pay rise – even if non-pensionable – can put somebody over both and result in a big tax charge.

Most in the private sector have avoided the issue by paying benefits in kind. However, public sector workers lack the flexibility to avoid getting stung with big charges due to being in defined benefit schemes. Usually the only way to avoid a big tax charge is to opt out of their pension – which can mean losing other valuable benefits such as death in service payments for dependents.

I’m sure some readers may not feel much sympathy for public workers and their defined benefit pensions. But it is not in society’s benefit for experienced doctors, firefighters, judges, and so on to do less work on account of arbitrary and complex tax rules.

The good news is that the Chancellor is reviewing [13] the taper. The bad news is that we’re unlikely to see any changes soon.

There appears to be a lack of appetite to scrap the taper. The much-promised pensions bill finally popped up in the queen’s speech – but there was no mention of the taper in sight (and besides, who knows what the Government will soon look like anyway!)

Money purchase annual allowance

In 2015 the Government brought in the fabled pension freedoms [14]. These changes necessitated the need to introduce a new allowance in order to prevent individuals crystallising a pension and then ploughing the money – plus a dollop of lovely tax-free cash – back into a pension.

Thus the money purchase annual allowance (MPAA) was born.

From 6 April 2015, an individual taking income from flexi-access drawdown or taking an uncrystallised funds pension lump sum triggers the MPAA.

Initially, the MPAA was at £10,000 before being dramatically slashed to £4,000 on 6 April 2017. The MPAA triggers if an individual:

It does not trigger when an individual:

The money purchase annual allowance applies to defined contribution pensions only, not to defined benefit accrual. However, defined benefit pension contributions are still tested against the annual allowance.

There is no carry forward of the money purchase annual allowance.

It’s worth noting too that the money purchase annual allowance doesn’t replace the current annual allowance. If applicable, the money purchase annual allowance and annual allowance will be calculated alongside each other.

Just like with the tapered annual allowance, the complex rules have lead to people falling into traps. The Office for Tax Simplification has called for it to be reviewed [16].

Annual allowance planning

It’s possible to avoid getting stung by the annual allowance with some careful planning.

The first thing to do is to keep track of unused allowances that can be carried forward.

Secondly, forecasting future salary changes and bonuses can help determine when the annual allowance may kick in and give you time to prepare.

Thirdly, most private sector employers are already alert to the annual allowance and in particular the tapered annual allowance, and so offer benefits in kind in lieu of pension contributions.

Also remember a golden rule of taxes:

Paying a tax charge isn’t necessarily a bad thing.

For example, an individual opting out of their pension to avoid a tax charge even when there is a net benefit is like them asking their employer to stop paying their salary because they’ll have to pay income tax.6 [17]

When assessing what you should do about the annual allowance, think about:

  1. What do you get? Consider levels of contribution, future salary increases, and any interactions with tapered allowance
  2. What does it cost you (net of tax relief) to get those benefits?
  3. Is there a net benefit after tax charges? If you’re in a defined benefit scheme with ‘scheme pays’ what is the commutation factor?
  4. What will you get if you stopped contributing today? (Consider the loss of other benefits such as death in service benefits)
  5. How valuable is the alternative benefit? (Your employer paying a benefit in kind)
  6. What will you do instead of contributing to the pension? Will you receive more salary? Invest in ISAs or other investment vehicles? Are there differences in access and risk factors compared to the pension?

To conclude where we began, this is a fiendishly complicated area so seek professional advice if you need it. And do let us know of anything we’ve missed in the comments below.

Phew – we made it!

  1. It’s a bit more complicated than that – what with tax-free cash and the lifetime allowance – but we have to at least try to simplify things! [ [20]]
  2. Note that if the difference in the following calculation is a negative amount then your pension input is nil – HMRC isn’t generous enough to give you extra allowance to carry forward for future years. [ [21]]
  3. If you have any lump-sum benefits, these are added after applying the 16 times factor. [ [22]]
  4. As we mentioned earlier, bear in mind that tax relief on pension contributions is capped at 100% of relevant UK earnings per tax year. [ [23]]
  5. £50,000 – £40,000 [ [24]]
  6. I’ve borrowed this excellent phrase from Pru Adviser. [ [25]]