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How can tax planning ensure you make best use of your pension annual allowance?

If you are planning your retirement, it is important to understand the amount you can put into your pension each year in order to gain valuable tax relief, known as the ‘annual allowance’. The rules are complicated and regularly change so you may want to ask one of our expert wealth planners for their advice to ensure you are optimising your pension tax planning.

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What is the pension annual allowance?

The annual allowance was introduced in 2006 as a way of simplifying some of the more complex legislation which went before. The basics are simple: the annual allowance is the maximum amount you can pay into a pension and receive tax relief; or the maximum an employer can contribute without a tax charge arising on their employee. At its peak, the annual allowance stood at £255,000 but, as it increasingly became used as a political tool to restrict relief for high earners, it settled at £40,000.

There are some basics you need to be aware of:

  • You must have pensionable income at least equal to the contribution, although this is not necessarily the case with employer contributions
  • If you have capacity to contribute more than the annual allowance you can ‘carry forward’ unused allowances from the previous three years, and
  • If you are carrying forward, you must have been a pension scheme member during the tax year(s) in which you were not using all of your allowances.

What happens if my pension contribution exceeds the annual allowance?

Where the annual allowance is exceeded you face an annual allowance charge. The excess contribution is added to your other income and charged at your marginal rate of income tax. For example, an additional rate taxpayer would face an annual allowance charge of £45 for every £100 they exceed the annual allowance.  For personal contributions, this is in effect a claw back of relief received; for employer contributions this becomes a penal tax charge given the member has not received relief personally.

How will the tapered annual allowance impact my pension tax relief?

Things became more complicated in the 2016/17 tax year when the tapered annual allowance was introduced. In essence, anyone with total ‘adjusted’ income in excess of £150,000 could be subject to a reduced annual allowance. In the March 2020 budget, the Chancellor increased the adjusted income level to £240,000.

Adjusted income is not limited to pensionable earnings, but includes dividends, rental income, interest, and employer pension contributions, amongst others. When it was first introduced, for those whose adjusted income exceeded £150,000, the annual allowance was reduced by £1 for every £2 in excess of £150,000. For those with total income of £210,000 or more, their annual allowance was £10,000.

Whilst members of money purchase pensions generally have full control over the level of pension contributions, members of defined benefit (or final salary) pensions have little flexibility, other than to opt out of the scheme altogether. Because many higher earners regularly faced annual allowance charges, the Chancellor increased the adjusted income level to £240,000. However, what he gave with one hand, he took away with the other, and the minimum annual allowance of £10,000 has been reduced to £4,000. This means anyone with earnings in excess of £312,000 will be limited to annual contributions of just £4,000.

The tapered annual allowance applies if your adjusted income level exceeds £240,000. Anyone with earnings in excess of £312,000 will be limited to annual contributions of just £4,000.

How is the annual allowance charge paid?

If you are subject to an annual allowance charge, it can be paid in one of two ways:

  • Via your annual tax return, or
  • Using a pension scheme to pay the charge, known as ‘scheme pays’.

The ‘scheme pays’ rules are not straightforward. If an individual:

  • Has exceeded their annual allowance, and
  • The annual allowance charge exceeds £2,000, and
  • Is not subject to tapering.

They can elect for the scheme to pay the charge on their behalf and the scheme is obliged to do so using the mandatory scheme pays rules. This election must be made prior to 31 July following completion of the annual tax return. For example, an individual who exceeds the annual allowance in the 2020/21 tax year, and meets the conditions above, must instruct the scheme to pay the charge by 31 July 2022.

If the conditions are not met, in particular if the individual is subject to a tapered annual allowance, the scheme is not obliged to pay the charge on behalf of the member. The scheme may agree to pay the charge on a voluntary basis, but payment must be made in line with the annual tax return. For example, an individual who exceeds the annual allowance in the 2020/21 tax year, must pay the charge by 31 January 2022. Late payment of this charge can incur penalties in the usual way and therefore most schemes will ask members for their election well in advance of the 31 January deadline.

How can we help with optimising your pension allowances?

What was once a relatively straightforward concept has become increasingly complex and as is usually the case, the devil is in the detail. Our team of independent Wealth Advisers can provide advice on all retirement planning matters. To discuss how to optimise your pension savings and use your annual and lifetime tax allowances to boost your pension, please get in touch for more information on +44 02 7523 4500 or book a free consultation.

If you want to read more about tax planning for retirement:

The tax treatment of all investments depends upon individual circumstances and the levels and basis of taxation may change in the future. Investors should discuss their financial arrangements with their own tax adviser before investing.

Photo of David Goodfellow

David Goodfellow

Head of UK Financial Planning

David specialises in financial planning and tax driven investment planning. He has over 15 years' experience in advising on and investing in VCTs, EISs and tax driven property structures, and is part of the CGWM Advice and Solutions Committee. He is a member of the Personal Finance Society and The Chartered Insurance Institute.

44 (0)20 7523 4738

Investment involves risk and you may not get back what you invest. It’s not suitable for everyone.

Investment involves risk and is not suitable for everyone.