Each year individuals can make a tax free contribution to their pension pot. Presently, for most regular tax payers, this is a maximum of £40K per year. However, the closer your income gets to £240,000 per annum, the closer the attention you’ll need to pay, as the amount you can contribute in each year starts to ‘taper off’, hence the term “pensions tapering”.
Every year, we like to make sure that our clients fully maximise their opportunity to contribute to their pension pot in a tax efficient manner. With recent changes in the pensions tapering rules and the lowering of the minimum allowance, we thought we would review the current state of affairs in regard to tax efficient pensions contributions and pensions allowance tapering.
What is the pension annual allowance?
This is simply the maximum amount that you are allowed to contribute to your pension pot and still receive tax relief.
Currently, this stands at £40K. However, if you are a higher tax bracket earner, this may be significantly reduced through the tapering of your annual pension contribution allowance, depending on your level of income within the tax year in question.
Does tapered pensions annual allowance apply to me?
We should point out immediately that if your net income is less than £200,000 and you’re unlikely to break this barrier through the addition of other sources of income, then it is highly unlikely you will be affected by tapering of the annual pensions allowance. Typically this only affects high earners and high net worth individuals (HNWI).
That said, if your regular income is significantly less than this, but for one reason or another find that you have an unexpected gain, perhaps through the sale of a second home, maturity of an insurance policy, you may find that tapering for the year the event occurs applies to you. This is why it is critical that you speak to a specialist accountant like Tax Agility, prior to any such event, so we can assess your individual situation and advise on a strategy to mitigate any undesirable and legally avoidable tax liabilities.
I am close to the £200K income level, how do I calculate a tapered allowance?
To correctly ascertain if you are impacted by pensions allowance tapering, there are four terms that need to be understood, so as to gain an accurate assessment of your actual income any payments made to pensions plans is concerned.
Net Income in the tax year in question. To be clear here, ‘net’ doesn’t simply mean ‘after tax’. In this case net means all taxable income less deductions. The deductions we are interested in here are those related to member’s contributions paid into any UK registered pension schemes. Add up any personal contributions made to employer pensions schemes – those that fall under a ‘net pay’ agreement. The add up any contributions you may have made personally through a ‘relief-at-source’ arrangement – these schemes typically accept pensions payments made net of tax and then within the pensions scheme are grossed up to the basic rate of tax. Once you have done this deduct these amounts from your total income, including any taxable overseas income (worldwide income).
Threshold income. This is the income you have just calculated – i.e. net of any pension payments. If your threshold income is over £200,000, you will be subject to pensions tapering.
Adjusted income. This is the total figure for your income including your pension payments. If your adjusted income is more than £240,000, you will be subject to pensions tapering.
What is the difference between threshold income and adjusted income?
The basic difference represents the £40,000 pensions contribution allowance. If your threshold income starts to exceed £200,000, your contribution allowance will naturally reduce. For example, If you receive £210,000 in income, your allowance will reduce to £30,000.
How is pensions allowance tapering applied when I exceed an adjusted income of £240,000?
Once you exceed the adjusted income threshold of £240,000, a tapered allowance formula kicks in. For every £2 your adjusted income exceeds £240,000, your annual allowance for the year in question, reduces by £1.
Here are some examples to show how this works in practice.
Scenario 1 – a reduced allowance
Bob has calculated his adjusted income as £290,000 for the tax year concerned. This exceeds the adjusted income threshold by £50,000. Applying the 2 for 1 rule, his pension contribution allowance therefore is reduced by £25,000, i.e £40,000 standard allowance minus the £25,000, leaving a £15,000 tapered allowance.
Scenario 2 – minimum allowance tapering
Alice had a good year and earned £350,000. This exceeds the adjusted income threshold by £110,000. Her allowance should therefore be reduced by £55,000, more than that available. In this case the government introduced a minimum annual allowance that the tapering would allow – this is £4,000. Therefore Alice’s new annual allowance is just £4,000, not nil.
Scenario 3 – over payment and carry forward entitlement
In scenario 2, Alice had benefited from pension contributions of £40,000. Her actual allowance had been tapered to £4,000. Therefore, Alice had an excess of £36,000. Ordinarily, this amount would be added to Alice’s taxable income (net of pensions payments made by her personally). As such Alice would have to pay income tax on this amount at the prevailing tax rate for her situation. This should be declared on her Self Assessment return.
However, this was an extraordinary year for Alice. In previous years, she did not make full use of her pensions allowance. The government allows you to carry forward up to three years of entitlement up to a maximum of 100% of her earnings. As Alice has more than £36,000 in unused allowances, this will offset any income tax liability.
Why high income earners and high net worth individuals should consider Tax Agility
It can be very easy to forget the complicated issues surrounding tax implications and pensions payments. There’s nothing worse than having a great year only to find out that the tax man is hammering on the door for additional payments or even a fine because you mis-reported your actual earnings on your self assessment form.
The Tax specialists at Tax Agility work with our high income / net worth clients to ensure that they have a clear view of potential pitfalls associated with issues like pensions payments and allowances. We will advise you of any possible issues that may arise because you’ve had a significant pay rise, moved into a higher paying job, the sale of stocks and shares or other such taxable event.
In short, our tax planning services can help minimise your tax liabilities and allow you to plan and mitigate future events that may have a significant impact.
Contact Tax Agility today on 020 8108 0090 and let us help you maximise your pensions contributions!
Disclaimer. This article is for information purposes only and should not be considered tax advice under any circumstances, as individual circumstances are unique. You should always contact a tax professional if you think the scenarios described in the article may relate to you. This way we can assess your personal situation and provide accurate tax advice.