What are the pension allowance carry forward rules and how do they work?

Discover how using the pension allowance carry forward allows you to enjoy pension tax relief, even if your contributions exceed your annual allowance.

Summary

• If you don’t use your full pension allowance in a given tax year, you can carry the difference forward over the next three tax years.
• Pension allowance carry forward rules do not apply once you have triggered the money purchase annual allowance (MPAA),
• Pension allowance carry forward rules are subject to certain criteria and have pros and cons for business owners and self-employed individuals.
• A financial adviser can help you with your pension and retirement plans.

What are the pension allowance carry forward rules?

In the UK, you can currently pay up to £60,000 into your private pensions in each tax year and still receive tax relief. This is referred to as your pension annual allowance. 

If you contribute less than your pension annual allowance, however, you can carry the unused allowance amount forward over the next three tax years. This is called a pension allowance carry forward.

What criteria have to be met to use carry forward?

There are four main criteria that you must meet in order to use pension carry forward:

• You must have been a member of a registered UK pension scheme during the applicable time period, even if you were not making contributions at that time. The state pension does not count in this instance.
• You must have used your full annual allowance in the tax year you wish to carry forward.
• You must claim the unused annual allowance from the earliest of the three years in question and can only do so once.
• If a pension tapered annual allowance is applicable to your situation, you must measure any excess annual allowance against that year’s tapered allowance.

What is the money purchase annual allowance (MPAA)?

Once you start to withdraw from your pension, your annual pension allowance is replaced by the money purchase annual allowance (MPAA).

This applies specifically to defined benefit pension schemes that involve building up your own individual pension fund. Such schemes are also referred to as money purchase pension schemes.

Essentially an allowance within an allowance, the MPAA exists to prevent people from attempting to avoid tax on existing earnings or obtain tax relief twice on the same income. Failure to comply with MPAA rules could result in fines.

Currently, the MPAA is £10,000 and is applied differently according to the tax year in which it is claimed. Additionally, the MPAA applies only to contributions made after it is triggered.

What will trigger the MPAA?

Certain actions, referred to as “accessing flexibility events,” will trigger the MPAA.

The following actions are examples of ways in which you can trigger the MPAA:

• You withdraw your entire pension pot as a lump sum.
• You set up a drawdown scheme using your pension pot and start to take income from it.
• You withdraw successive taxable lump sums, also known as uncrystallised funds pension lump sums (UFPLS), from your pension pot.
• You purchase a flexible or investment-linked annuity that may see a reduction in your income.
• You exceed the cap of your income if you have a capped drawdown pension plan.

Fortunately, there are ways to avoid triggering the money purchase annual allowance.

What will not trigger MPAA?

There are a few scenarios in which you can access your pension funds without triggering the MPAA, for example:

• You take a tax-free lump sum and buy an annuity that gives you a guaranteed minimum income.
• You take a tax-free lump sum from your pension pot and set up a drawdown scheme but don’t yet take any income from this scheme.
• You cash in pension pots with a value of less than £10,000.

Finally, the MPAA only applies to contributions that you make to defined contribution pensions. It doesn’t affect defined benefit pension schemes.

What if I’m self-employed?

If you’re self-employed, and your income varies considerably from year to year, you may want to consider the benefits of spreading your pension tax relief over three years.

If you are eligible, you can do this using the pension allowance carry forward.

Pros:

• You can make larger pension contributions during high-income periods.
• You can maximise tax relief by carrying forward the pension allowance from less profitable years.
• If you breach the limits of your threshold income as well as your adjusted income, your annual pension allowance could be tapered to as little as £10,000. By using carry forward, you can stretch these benefits.

Cons:

• You cannot benefit from pension tax relief like carry forward unless you earn at least the amount you wish to contribute in the tax year in question. This same rule does not apply to individuals whose contributions are made on their behalf by their employers.

What if I run my own business?

Pension allowance carry forward rules apply differently to business owners than those who are self-employed or employed by someone else.

Pros:

• You can make larger contributions during profitable years, reducing your tax burden and increasing your retirement savings.

Cons:

• Contributions not made for the purpose of the business do not qualify for carry forward tax relief.
• Large contributions could eat into your company's profits, as well as the amount of dividends that can be paid out to you.

What is the wholly and exclusively test?

The wholly and exclusively test applies to UK corporation tax.

Pension contributions have to be made wholly and exclusively for business purposes in order to be eligible for deductions against trading profits.

Seek expert financial advice

Understanding the pension allowance carry forward rules can help you make the most of the tax relief available to you.

Spreading out your pension allowance and avoiding triggering the MPAA can go a long way to improving your post-retirement finances.

To learn more about pensions and for expert financial advice, let Unbiased match you with a trusted financial adviser.