For high earners, the Tapered Annual Allowance (also known as the Tapered Pension Annual Allowance) can have a significant impact on pension savings and incur large tax charges. Before covering the tapered annual allowance in more detail, let’s recap about the Pension Annual Allowance:
What is the Pension Annual Allowance?
The Pension Annual Allowance is the total amount of pension contributions you can make in one year that benefit from tax relief. As you may know, when you contribute to your pension, the amount you put in is “grossed up” by your marginal rate of tax. Therefore, if you are a basic rate taxpayer and contribute £5,000 into your pension, the Government will add 20% to this so your pension increases by £6,000. Please note that if you do not pay any tax, your contributions will still be grossed up by 20%. This grossing up can only happen if your total contributions in that tax year (including employer contributions) are below the Pension Annual Allowance.
To be perfectly clear, this is not the maximum you can contribute to your pension in the tax year. You can contribute as much as you like, but you will not receive any benefits from the amounts contributed over and above your annual allowance.
Should you exceed your annual allowance in a tax year and have benefited from the tax benefits on your full contribution, then you may receive a tax charge equivalent to the grossed up amount.
How much is my Annual Allowance?
The annual allowance is the higher figure of:
- £3,600
- Your total earnings in the tax year (up to a maximum of £40,000)
Example 1 – someone earning £10,000 per year has an annual allowance of £10,000.
Example 2 – someone earning £2,500 per year has an annual allowance of £3,600.
Example 3 – someone earning £75,000 per year has an annual allowance of £40,000.
For high earners with income over £240,000, the annual allowance tapers back from £40,000. Read on for more information about this.
What pension savings are measured against my Annual Allowance?
This depends on the type of pension scheme that you contribute to. Your annual allowance considers your total pension savings so if you have more than one type of scheme, you will need to total your contributions together and compare that your annual allowance.
For defined contribution schemes, such as money purchase workplace schemes, stakeholder pensions, personal pensions and SIPPs – this is based on the total of:
- Your contributions
- Any tax relief (or grossed up amount) received
- Employer contributions
- Contributions made by someone else
For defined benefit (also called final salary) schemes – this is based on the increase in capital value of your pension benefits throughout the tax year. This is slightly more complex to calculate but if you ask your pension provider they will be able to give you this information.
Can I carry forward unused allowance from previous tax years?
Luckily, yes you can. Unused annual allowance from the past 3 tax years can be carried forward to the existing tax year. This can be helpful when you have used all of your annual allowance for the current tax year. When doing this, you use the unused allowance from the earliest tax year first, and then use up the following tax year allowances if required. You can only use unused allowances from a past tax year if you were a member of a UK-registered pension scheme in that tax year. This does not mean you must have made contributions, only that you were a member. Any excess amounts of pension savings over and above your annual allowance should be included on your self-assessment tax return.
Example
You earn £30,000 per year and therefore have an annual allowance of £30,000.
After receiving a sum of money from family, you decide to make additional pension contributions in this tax year. Your total pension contributions for the tax year are already £8,000 and you wish to contribute an additional £50,000. This would take your total contributions over your annual allowance.
However, you decide to check the previous 3 tax years to see if you have any unused allowance.
Previous tax year – earned £30,000 and total contributions of £8,000 – you have £22,000 unused allowance
2 tax years ago – earned £28,000 and total contributions of £7,000 – you have £21,000 unused allowance
3 tax years ago – earned £28,000 and total contributions of £6,000 – you have £22,000 unused allowance
Starting with the earliest year, so 3 tax years ago, you are able to use up these unused allowances and could therefore contribute £65,000 in addition to your remaining £22,000 annual allowance in the current tax year.
What is the Tapered Annual Allowance?
For high earners, the Annual Allowance is tapered to below £40,000. This is not straightforward to calculate as it is based on your adjusted income. For information on working out your adjusted income, please see this useful Government webpage, or get in touch with us.
When does the Tapered Annual Allowance apply?
First your threshold income must be calculated. If this is over £200,000 for the current tax year, then you can move on to working out your adjusted income. If your adjusted income is over £240,000 AND your threshold income over £200,000, then your annual allowance begins to taper. For every £2 that your adjusted income exceeds £240,000, £1 of your annual allowance is lost. However, the lowest that it can be reduced to is £4,000.
For example – someone with an adjusted income of £300,000 would have an annual allowance of £10,000. And someone with an adjusted income of £400,000 would have an annual allowance of £4,000 as this is the minimum that it can be tapered to.
What is threshold income?
This can also be known as net income, threshold income looks at all your taxable income minus certain deductions. As a reminder, for the tapered annual allowance to apply, threshold income will need to be above £200,000.
The various aspects used to calculate your threshold income are:
- Taxable income such as salary, pension income, trading profits, rental income, dividend income
- Taxable lump sum pension death benefits from the current tax year
- Employment income sacrificed for pension contributions (eg. Salary sacrifice)
- Gross amount of any relief at source pension contributions
Using these aspects, the formula is:
Taxable income – gross relief at source pension contributions + employment income sacrificed for pension contributions since 2015 – taxed lump sum death benefits received in current tax year
What is adjusted income?
Adjusted income is very similar to threshold income, but factors in employer pension contributions. This is done so that employees can’t avoid the tapering by maximising employer contributions.
The formula for calculating this is:
Taxable income + employer pension contributions – taxed lump sum death benefits received in current tax year
When was the Tapered Annual Allowance introduced?
Many clients ask me “when did the Tapered Annual Allowance start”? This was introduced on 6th April 2016 in an effort to reduce the Government cost of tax relief when it comes to pensions. They wanted to ensure that tax relief is fair for all areas of society whilst staying affordable.
Initially, the pension Tapered Annual Allowance applied for those with a threshold income of over £110,000 and adjusted income of over £150,000 but this was raised to today’s limits on 6th April 2020, giving the tapered annual allowance 2022/23 limits of £200,000 and £240,000.
