It’s a difficult concept: pension contributions and tapered annual allowance. Examples are the best way to reveal the story behind the numbers, so you can see how tapered annual allowance might affect your own pension contributions. Below we have three examples to consider. But first…
What is the tapered annual allowance?
The typical saver is entitled to pay up to £40,000 each year into their pension tax free. But high earners are treated slightly differently.
Introduced on 6th April 2016, the tapered annual allowance is designed to curb the tax benefits available to high earners. It works by reducing the amount of tax relievable pension contributions they can make in any one tax year. The aim of tapered annual allowance is to try and make sure high earning individuals aren’t abusing tax relief as they accumulate retirement wealth.
How does tapered annual allowance work?
For the 2020/2021 tax year, the tapered annual allowance rules kick in when you have both a ‘threshold income’ of more than £200,000 and an ‘adjusted income’ of more than £240,000. (Both limits must be exceeded for the taper to apply to you.)
If you tick both boxes, your annual allowance (the amount you can add to your pension fund(s) each year) will be reduced by £1 for every £2 of adjusted income over £240,000.
So firstly we need to understand how to work out the difference between threshold income and adjusted income.
A quick introduction to threshold income
In a nutshell, your threshold income is your total taxable income for the year, minus any pension contributions that you have made. Note: when calculating your threshold income, you must include all taxable income – not just your basic salary. Make sure you factor in income from things like buy-to-let properties, dividends and savings interest.
There are additional deductions that can be made from your threshold income – beyond pension contributions – such as lump sum pension death benefits. Get in touch and we can explain over the phone.
What is adjusted income?
If your threshold income exceeds £200,000, it’s time to calculate the value of your adjusted income. Again, that starts with calculating your total income for the year. Then add in the value of the total contributions to your pension scheme for that year (including contributions that your employer has made). If your adjusted income exceeds £240,000, your annual allowance for that tax year will be reduced. And any excess contributions to your pension will be subject to income tax at your nominal rate.
It all sounds complicated but stay with us. The examples below will help.
Calculating your annual allowance
Your annual allowance is the maximum tax-free pension contribution that you can make in a given tax year. For most people that figure is set at £40,000. But if you exceed the limits for threshold income and adjusted income, your annual allowance will be reduced.
The maximum reduction to your annual allowance is currently fixed at £36,000 (2020/2021), for which you will need to be £72,000 over the adjusted income limit. Essentially it means that if your adjusted income is £312,000 or more, your annual allowance will shrink to £4,000. Contributing more than this figure to your pension will incur tax charges, unless you make use of the carry forward rules. We will look at those rules shortly. But first let’s look at some tapered annual allowance examples.
Tapered annual allowance examples
Example 1: George
Employment income: £80,000
Rental income: £30,000
Dividends income: £1,500
Personal pension contributions: £10,000
Employer pension contributions: £10,000
Threshold income: £101,500 (£80,000 + £30,000 + £1,500 – £10,000)
Adjusted income: £131,500 (£80,000 + £30,000 + £1,500 + £20,000)
As you can see, George’s threshold income and adjusted income are both within permissible limits. Therefore the taper isn’t relevant and his annual allowance remains unchanged at £40,000.
Example 2: Emily
Employment income: £200,000
Rental income: £30,000
Dividends income: £15,000
Personal pension contributions: £13,000
Employer pension contributions: £12,000
Threshold income: £232,000 (£200,000 + £30,000 + £15,000 – £13,000)
Adjusted income: £260,000 (£200,000 + £30,000 + £15,000 + £25,000)
Emily exceeds the allowable limits for both threshold income and adjusted income. Therefore an adjustment must be made to her annual allowance, which is reduced by £1 for every £2 of adjusted income over £240,000.
Because Emily is £20,000 over the adjusted income limit, her £40,000 annual allowance is reduced to £30,000. Any annual pension contributions beyond this limit will incur tax charges at her nominal rate.
Example 3: Lana
Employment income: £260,000
Rental income: £15,000
Dividends income: £1,000
Personal pension contributions: £20,000
Employer pension contributions: £20,000
Threshold income: £256,000 (£260,000 + £15,000 + £1,000 – £20,000)
Adjusted income: £316,000 (£260,000 + £15,000 + £1,000 + £40,000)
Like Emily, Lana exceeds the limits for both threshold income and adjusted income. Her adjusted income is £76,000 over the permissible limit, which – on paper – means her annual allowance should be reduced by £38,000 to £2,000. However, remember that the maximum reduction to annual allowance is capped at £36,000. So Lana is left with an allowance of £4,000, down from £40,000.
Taking advantage of the carry forward rules
Each year you are within the permissible limits of threshold income and adjusted income, you are able to make tax-free pension contributions of up to £40,000. However if you don’t use that full allocation, you can carry forward the unused amount to the next tax year, and so on. You can carry forward up to three years of unused allowance, which allows you to offset sudden spikes in income and make pension contributions beyond your annual allowance without incurring tax charges.
Tax and pension contributions can be complicated. We can help.
As highly experienced independent financial advisers, we have helped thousands of savers find the most efficient and viable routes to maximise their wealth and save for the future. We can do the same for you. An initial consultation is completely free. Get in touch to see how we can help your money go further. CONTACT US This article was written by Adam Prestwood.