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 you contribute to when calculating your pension savings. 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 them to your annual allowance.
Defined Contribution Schemes
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
How are Defined Benefit Schemes affected?
Pensions contributions are crucial in calculating adjusted income and annual pension savings. Defined benefit (also called final salary) schemes are based on the increase in the capital value of your pension benefits throughout the tax year. It 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 three tax years can be carried forward to the existing tax year. This can be helpful when you have used all of your annual allowances for the current tax year. When doing this, you use the unused allowance from the earliest tax year first then use up the following 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; it is only that you were a member. Any excess pension savings over and above your annual allowance should be included on your self-assessment tax return.
Worked Example
You earn £30,000 per year and therefore have an annual allowance of £30,000.
After receiving money from your family, you decide to make additional pension contributions 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 three tax years to see if you have any unused allowance.
In the previous tax year, you earned £30,000 and made a total contribution of £8,000. You have a £22,000 unused allowance.
Two tax years ago, you earned £28,000 and made a total contribution of £7,000. You have a £21,000 unused allowance.
Three tax years ago, you earned £28,000 and made a total contribution of £6,000. You have a £22,000 unused allowance.
Starting with the earliest year, so three tax years ago, you can 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 based on adjusted incomes. Calculating this is not straightforward as it is based on adjusted income. For information about pensions advice, or 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 is over £200,000, 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. 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. This minimum tapered annual allowance of £4,000 applies to individuals with an adjusted income exceeding the set thresholds, highlighting its significance in calculating pension contributions and carry-forward provisions.
Understanding the Tapered Annual Allowance Calculation
The tapered annual allowance calculation can be quite intricate, involving a detailed assessment of both threshold income and adjusted income. Threshold income is essentially your net income for the tax year, encompassing all taxable income such as employment income, dividends, and rental income. Adjusted income, on the other hand, includes your net income plus any pension contributions made by your employer.
To determine your tapered annual allowance, you first need to calculate your threshold income. If this amount is £200,000 or more, you then move on to calculating your adjusted income. Should your adjusted income exceed £260,000, your annual allowance begins to taper. Specifically, for every £2 that your adjusted income surpasses £260,000, you lose £1 of your annual allowance. This tapering continues until your adjusted income reaches £360,000, at which point your annual allowance is reduced to a minimum of £10,000 per year.
For example, if your adjusted income is £300,000, your annual allowance would be reduced by £20,000, leaving you with an annual allowance of £20,000. If your adjusted income is £360,000 or more, your annual allowance would be tapered down to the minimum of £10,000.
What is threshold income?
Income tax can also be known as net income. Threshold income looks at all your taxable income minus certain deductions. As a reminder, threshold income must be above £200,000 for the tapered annual allowance to apply.
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, for example (e.g. Salary sacrifice)
The 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 the current tax year
What is adjusted income?
Adjusted income, as defined by the Income Tax Act, is similar to threshold income but is a factor in employer pension contributions. This is done, so 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 the current tax year
Pension Contributions and the Taper
Pension contributions are a pivotal factor in the tapered annual allowance calculation. Employer pension contributions are added to your net income to determine your adjusted income. This means that if you receive substantial employer pension contributions, you are more likely to be affected by the taper.
Personal pension contributions, however, are not added to your net income for the purposes of calculating the tapered annual allowance. Despite this, they can still influence your tax relief. By making significant personal pension contributions, you may be able to reduce your taxable income and potentially avoid the taper.
For instance, if your net income is £250,000 and you receive £20,000 in employer pension contributions, your adjusted income would be £270,000. This would result in a tapered annual allowance. Conversely, if you make large personal pension contributions, you might lower your taxable income enough to stay below the threshold for the taper.
Anti-Avoidance Rules
The anti-avoidance rules are in place to prevent individuals from circumventing the tapered annual allowance through salary sacrifice or flexible remuneration arrangements. These rules apply to any arrangements entered into after 8 July 2015 and require that any sacrificed income be added back to your threshold income.
Additionally, the anti-avoidance rules extend to bonus sacrifice arrangements. If you enter into a bonus sacrifice arrangement, the sacrificed bonus must be added back to your threshold income. This means that even if you attempt to avoid the taper by sacrificing your bonus, you may still be subject to the tapered annual allowance.
For example, if you have a threshold income of £190,000 and sacrifice a £20,000 bonus, your threshold income would be recalculated to include the sacrificed bonus, bringing it to £210,000. This would then subject you to the tapered annual allowance rules.
By understanding these rules and how they apply, you can better navigate the complexities of the tapered annual allowance and make informed decisions about your pension contributions.
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’s cost of tax relief on pensions by implementing a reduced annual allowance for individuals with higher taxable incomes. They wanted to ensure that tax relief is fair for all areas of society while 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.