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What is the pension annual allowance and how does it work?

Updated 14 December 2020

4min read

Nick Green
Financial Journalist

Annual allowance

There is a limit to how much you can contribute into your private pensions each tax year, and this limit is called the annual allowance. Read on to find out what this limit is, how it may change and how it affects the different types of pension schemes.

What is the annual allowance?

The pension annual allowance is the most you can pay into pensions in a single tax year, and still receive tax relief. Currently this is either £40,000 or 100 per cent of your qualifying earnings (whichever is lower). It’s important to note that the allowance covers all your private pensions combined – so if you have, say, a personal pension and a workplace pension, you would have to split the allowance between them (e.g. £20,000 into each).

What happens if I exceed my annual allowance?

There are two main consequences of going over your annual allowance. The first is that you won’t receive tax relief on the excess amount. The second, more serious issue, is that you will face an addition to your tax bill for that year (called the annual allowance charge). The excess contributions are added to your gross income for that year, and your income tax bill is recalculated accordingly based on this higher figure. If the charge is over £2,000 then you can ask for it to be deducted from your pension benefits instead.

What counts towards the annual allowance?

All of your contributions into your pension pots, plus any that your employer makes, counts towards your annual allowance. Tax relief also counts, so the amount you can pay in is actually less than £40,000 of your net salary (because tax relief at 20% effectively increases each contribution by 25%). This is why it’s important to keep careful track of your contributions if you think you might be near the limit.

How do I calculate my annual allowance?

HMRC offers a series of calculators on its website to help you work out whether you have exceeded the annual allowance. Most people affected by this issue will want to use this calculator, but others are available for those whose circumstances are different.

Can I carry forward my annual allowance?

You can carry forward any unused annual allowance from the past three tax years. So for example, if your salary is over £40,000 and you paid £30,000 into your pension in the tax years 2018/19, 2019/20 and 2020/21, then you would have ‘saved’ £10,000 worth of allowance in each of those years, making a total of £30,000. This means that – assuming you had enough money to do so – you could add this to your allowance for 2021/22 and contribute a total of £70,000 in that tax year.

Note however that you can’t do this if you are already on the Money Purchase Annual Allowance (see below). Also be aware that if you make large contributions into your pension, you may eventually risk exceeding your lifetime allowance.

How does the annual allowance work for final salary pensions?

Final salary pensions (also known as defined benefit pensions), work in a different way from pension pots. They provide a guaranteed income for life, so there is no definite pot size on which to base the sums. This makes it more complex to calculate how close you are to the annual allowance. Usually, you will have to ask your pension scheme or a financial adviser to work this out for you.

Broadly, however, the allowance is worked out like this. First, the total value of your pension is calculated, based on how much income it could provide over a typical retirement. This calculation is done at the start of the year, and then again at the end of the year. The difference in these figures is considered to be the amount ‘contributed’ to the pension. If this figure exceeds the annual allowance, then there will be the annual allowance charge to pay.

What is the annual allowance taper and who is affected?

People with very high income have a reduced annual allowance. Up to an adjusted income of £240,000 you receive the full annual allowance. However, for each £2 of adjusted income over this figure, your annual allowance is reduced by £1. This continues until you reach the minimum annual allowance of £4,000 (which you would do at an income of £312,000.

Adjusted income is your total income plus any pension contributions you make in that year that aren’t from your income (so you can’t get around this by using salary sacrifice, for example).

When might my annual allowance be lower?

Your annual allowance can be reduced in two ways: either if you earn over £240,000 (see above) or if you start to access your pension pot(s) in a way that qualifies as a ‘trigger event’.

A trigger event is usually setting up a drawdown scheme (but not an annuity). This reduces your annual allowance to the Money Purchase Annual Allowance (MPAA) which is £4,000. Find out more about the MPAA.

Does the annual allowance change each year?

The annual allowance does not change regularly, but it has changed significantly in recent years. It changed from £255,000 to £50,000 in 2012 and again to £40,000 in 2014. The reduced annual allowance (MPAA) also changed from £10,000 to £4,000 in 2017.

It seems unlikely that there will be further reductions, but the possibility can’t be ruled out.

Find out what is a good amount to pay into your pension, and talk to a financial adviser if you’re concerned about exceeding your pension annual allowance. This can be a particular risk for those who have final salary pensions, such as workers in the NHS.

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About the author
Nick Green is a financial journalist writing for Unbiased.co.uk, the site that has helped over 10 million people find financial, business and legal advice. Nick has been writing professionally on money and business topics for over 15 years, and has previously written for leading accountancy firms PKF and BDO.