Updated 03 December 2020
You can normally pay up to £40,000 into a pension each year and receive tax relief on it – this is your annual allowance. But you need to beware of not one but two big risks to your allowance, which could cost you a lot in tax. Article by Nick Green.
When you first heard about the pension annual allowance, you may have thought, ‘So what? I’d love to be rich enough to have that problem.’ Yes, it may look like an issue affecting only the very wealthy. But if you don’t know all the details, you could be in for a nasty shock. Here’s why.
First, a quick recap of how tax relief works. When you pay into a money purchase pension, you get tax relief at your marginal rate (the highest rate at which you pay income tax). If you pay at the higher rate (40 per cent), that translates into a big chunk of extra money going into your pension – an additional forty pence for every sixty pence you pay in. In other words, higher-rate tax relief comes quite close to doubling your contributions.
There’s a limit on how much you can pay into pensions each year and still receive tax relief – this is your annual allowance. You can also carry over unused annual allowance from up to three previous tax years. The usual limit of £40,000 per year is the total amount you can pay into all schemes, and includes employer contributions too. However, it can be slashed to as little as £4,000 in two separate scenarios.
The first threat to your annual allowance is when you start to draw your pension pot. The second threat is having too much ‘adjusted income’ (N.B. not the same thing as your salary).
More people could be affected by the first threat than the second, so we’ll tackle them in that order.
You can access your pension pot at any time from the age of 55. This provides great flexibility if, for instance, you want to keep on working part-time while also drawing some of your pension. You can also continue to pay into your pot after starting to make withdrawals. However, if you have begun to take flexible benefits (e.g. drawdown) or have withdrawn more than the 25 per cent tax free lump sum, your annual allowance reduces to £4,000 per year, and is then called the money purchase annual allowance (MPAA). Furthermore, you can’t carry forward any unused MPAA as you could with the standard annual allowance.
Maybe you assume that you won’t in any case pay more than £4,000 into your pension in a year. But as you near retirement, you may want to transfer other savings into your pension to boost their value – and these could easily total much more than £4,000.
If your earnings are above £150,000, your annual allowance will be 'tapered' - that is, it will fall by £1 for every £2 of income over £150,000, up to a maximum reduction of £30,000. This will affect those earning at least £210,000.
However, if your actual salary is less than £150,000 then you could still be affected. The rule takes into account your total adjusted income, which includes employer pension contributions, income from property, dividends, interest on savings and any other taxable income. These means that many people who assume they are not affected may find that they are.
The big danger here is not knowing exactly how much your adjusted income will be. Many factors could lift you over the threshold, including pay rises, bonuses and employer pension contributions. It may be particularly difficult if you run your own business, since you won’t know your final profits until the year end.
If you pay in more than your annual allowance, you’ll be subject to a tax charge. The size of the charge will depend on your taxable income and by how much you’ve exceeded the allowance.
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