Pension contributions can reduce your tax liability by increasing the tax thresholds, or by reducing taxable income if net pay scheme or if salary sacrifice is used for any type of scheme. The annual allowance for 2022/23 is £40,000. To avoid an annual allowance tax charge, the pension contributions made by yourself, and by your employer on your behalf, must be covered by your available annual allowance.
If you haven’t used all your allowance in the last three tax years, it might be possible to pay more into your pension plan by ‘carrying forward’ whatever allowance is left to make the most of the tax relief on offer. But bear in mind the amount of tax-relievable personal contributions is still capped at 100% of your earnings.
However, different rules apply if you’ve already started to take money out of your pension plan flexibly and you’re affected by the Money Purchase Annual Allowance, or if your income when added to your employer’s payments is more than £240,000 (and income excluding pension contributions is over £200,000). Further information can also be found at gov.uk.
Tapered Annual Allowance
Pension Annual Allowance Alternative
Not everyone will have the full Pension Annual Allowance of £40,000 available to them. High earners may have a reduced allowance due to ‘tapering’. For high earners, tapering starts if your adjusted income exceeds £240,000 and your threshold income exceeds £200,000. These figures are effective from the 2020/21 tax year (with £150k/£110k applying in 2016/17 – 2019/20).
Calculating threshold and adjusted income can be quite complicated so regulated financial or tax advice may be required. To work out if you have a reduced (tapered) annual allowance for a tax year, you’ll need to work out your:
- Net income in that tax year
- Pension savings in that tax year
- Threshold income in that tax year
- Adjusted income in that tax year
For every £2 your adjusted income goes over £240,000, your annual allowance for the current tax year reduces by £1. For example, if your adjusted income was £280,000 your annual allowance would be reduced to £20,000.
This ‘tapering’ stops at £312,000, so everyone will retain an allowance of at least £4,000.
If you’re affected by the taper and the contributions to your pensions exceed your reduced annual allowance, first check if you may be able to use carry forward to reduce or remove any excess. This could potentially restore you to the normal annual allowance for that tax year, or more.
Carrying Forwards
Carry forward relates to unused annual allowance from the three previous tax years. To be able to use it you must have been a member of a registered pension scheme in each of the tax years from which you wish to carry forward from. Any unused annual allowance must be used from the earliest year first. If you are subject to a tapered annual allowance, you need to measure any unused annual allowance against the tapered allowance for each given year.
If there’s still an excess amount after carrying forward, you will face a tax charge on this amount. The amount will be added to your income and will be subject to Income Tax at your highest marginal rate. For more information on how to work out your reduced annual allowance visit: gov.uk
The Pension Lifetime Allowance (LTA)
The LTA is the amount of tax relieved pension savings you can accrue during your lifetime without suffering an additional tax charge. This has been severely reduced in recent years and is currently £1,073,100. This allowance has now been frozen until April 2026.
The LTA affects high earners and those approaching retirement age the most, including those with defined benefit pensions. As the value of high earners’ pensions rises over the next three years towards a lifetime limit that will remain fixed, more and more individuals may find they need to stop contributing to avoid breaching the limit.
Once you have crystallised your full LTA in pension benefits, you will be required to pay an additional tax charge on any further benefits you crystallise. The rate of tax you pay on pension savings above your lifetime allowance depends on how the money is used – the rate is:
- 55% if you take the excess as a lump sum (i.e. without placing the excess funds in drawdown first)
- 25% if you use the excess funds for an income purpose, e.g. annuity purchase or placing the funds in drawdown (25% is deducted from the excess funds upfront and then normal income tax is then paid on any income taken)
Some people may benefit from LTA protection which gives them a higher LTA than the current figure. This can be anything up to an unlimited amount with Enhanced Protection, £1.8m for FP12 etc. These protections may be useful if you have a pension pot which already exceeds the current LTA or may exceed the current LTA at retirement, even if you stop your pension saving now. It’s worth noting only FP16 and IP16 can be applied for now – the deadlines for all other types have passed.
Further information on protecting your LTA can be found here: https://www.gov.uk/guidance/pension-schemes-protect-your-lifetime-allowance or speak to your adviser to see if there are other savings options that you can make and avoid being hit by a penalty tax charge.
To discuss any of the issues raised in this article, please contact us. Further information can also be found at gov.uk.
Personal circumstances differ and not all of this information is applicable to every client and/or their business, this information is general in nature and should not be relied upon without seeking specific professional financial advice.
The Financial Conduct Authority (FCA) does not regulate tax advice, estate planning, trusts or will writing.
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Thresholds, percentage rates and tax legislation may change in subsequent finance acts. Levels and bases of, and reliefs from, taxation are subject to change and their value depends on the individual circumstances of the investor. The value of your investments can go down as well as up and you may get back less than you invested. Past performance is not a reliable indicator of future results.
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