Navigating the annual allowance

With the first two months of 2023 already behind us, tax year end is fast approaching. You may have clients who are just now beginning to think about topping up their pension contributions for the year and understanding exactly how much they can contribute can sometimes be tricky.

Pensions legislation doesn’t set a fixed limit on how much someone can contribute to their pension each year. This is a marked difference from ISAs where there is a subscription allowance of £20,000 each year which can’t be exceeded.

However, although in theory people can pay into pensions whatever amount they want, personal pension contributions will only receive tax relief up to 100% of someone’s relevant UK earnings (which is broadly salary and other earned income taxable in the UK). Running alongside this is also another general limit on pension contributions, the annual allowance.

The concepts of tax relief and annual allowance are often misunderstood. This article will focus on the annual allowance, explaining what it is, and explaining some of the nuances you might want to consider when planning for your clients.

What is the annual allowance?

The annual allowance is a general limit on how much someone can contribute tax-efficiently to their pensions each tax year. It is currently £40,000. Importantly, the annual allowance doesn’t prevent someone from receiving tax relief on their contributions.

Contributions made during a ‘pension input period’, whether by the individual, someone else on their behalf, or by their employer, are all measured against the annual allowance. Any tax relief claimed by the scheme administrator via relief at source is also included. Since 2016/17, the pension input period for all types of pensions has been aligned with the tax year.

In defined contribution schemes it is simply the cash value of the contributions which is measured, but defined benefit schemes use a more complicated calculation to assign a value. This calculates the increase in accrued benefits over the course of the tax year by comparing the opening value of the annual pension which has built up, valued using a factor of 16:1 and uprated by CPI, with the closing value. The difference between the two figures is the pension input amount measured against the annual allowance.

Frustratingly, this valuation method means it can be difficult for members of defined benefit schemes to fully understand how much annual allowance they have used until the end of the tax year. This makes it difficult to fully use the allowance, for example through additional contributions to a defined contribution scheme, so may mean members exceed the annual allowance unexpectedly.

The annual allowance charge

Contributions can exceed the annual allowance. Provided the member has sufficient earnings, tax relief is still available on personal contributions as usual.

However, the gross amount contributed in excess of the annual allowance is subject to a tax charge calculated at the individual’s tax rate.

Contributions exceeding the annual allowance can’t be refunded to avoid paying a tax charge. Not only is this not sufficient grounds for a refund in HMRC’s eyes, and could be treated as an unauthorised payment, the Pensions Tax Manual confirms that the annual allowance tax charge would still apply.

The good news is that the annual allowance tax charge isn’t punitive. It effectively neutralises the tax relief received on the contribution. It is calculated by adding the value of the excess contributions to the member’s taxable income for the tax year and applying the corresponding rate of Income Tax. More than one rate of tax may apply.

Due to the way the charge is calculated, it’s important any higher or additional rate taxpayers who are paying into relief at source schemes remember to claim any extra tax relief they’re entitled to from HMRC.

There are two options for paying the charge. The first is to pay the charge personally to HMRC through self-assessment, but if your client doesn’t wish to do this, they may be able to use the ‘scheme pays’ method which allows the charge to be paid directly from their pension.

A pension provider can be asked to pay an annual allowance charge from their scheme if the charge is at least £2,000, and contributions to the scheme that tax year exceed the £40,000 standard annual allowance.

To use scheme pays, your client must notify their pension provider by 31 July in the year following the year in which the tax year to which the annual allowance charge relates ended. For example, if the charge relates to the 2021/22 tax year, they must notify the scheme administrator by 31 July 2023.

Where these conditions aren’t met, or the deadline for notifying the scheme is missed, the scheme may still offer to pay the charge on a voluntary basis. Although it isn’t offered by all schemes, voluntary scheme pays can help limit the impact of the annual allowance charge on your client’s pension as it allows the charge to be paid by a different scheme than the one the excess contributions were made to. This can be particularly useful for those with defined benefit schemes, who may opt for the charge to be paid from a defined contribution scheme where the impact on their future benefits will be lessened.

When the annual allowance is restricted

Whilst the standard annual allowance is £40,000, there are two circumstances where someone may have a reduced amount.

The first is where the annual allowance for higher-earning individuals may be tapered and reduced to as little as £4,000. Where the taper applies, the annual allowance is reduced at a rate of £1 for every £2 of income above £240,000.

Higher earners are those who have:

Both the adjusted income and threshold income limits must be exceeded for the taper to apply.

Adjusted income is income chargeable to Income Tax from all sources (so includes investment income, not just salary) plus any pension contributions paid in the relevant period. This means sacrificing salary or bonus payments for employer contributions isn’t effective in reducing adjusted income.

The threshold income test is to protect people who have a spike in earnings from being unfairly impacted by the taper. Threshold income consists of income chargeable to Income Tax from all sources (so again includes investment income, not just salary), plus any salary sacrifice or flexible earnings set up on or after 9 July 2015, minus any personal contributions entitled to relief at source tax relief. Personal contributions may therefore be used to reduce the threshold income figure to avoid triggering the taper.

The second situation where the annual allowance can be reduced is where the Money Purchase Annual Allowance (MPAA) has been triggered. The MPAA is triggered when flexible pension payments are drawn from a defined contribution scheme for the first time. This includes:

The MPAA is not triggered if only a pension commencement lump sum is taken, or if flexi-access drawdown income is taken from a disqualifying pension credit or a beneficiary’s drawdown.

The MPAA will reduce the annual allowance for defined contribution schemes to £4,000. A quirk to be aware of is that in the tax year the MPAA is triggered, any contributions to defined contribution schemes made prior to the trigger date aren’t tested against the MPAA. Instead, they are tested against the standard £40,000 annual allowance (lower if subject to the tapered annual allowance).

Carry forward

Carry forward allows the member to take unused annual allowance from the previous three tax years and use it to increase their allowance for the current tax year. By doing this, they can make a larger contribution without exceeding their annual allowance and incurring a tax charge. They must use up their full annual allowance in the current tax year before they can carry forward unused allowance from previous tax years. It can’t be used in conjunction with the MPAA.

Your client also needs to have been a member of a registered pension scheme to carry forward from that tax year. This includes not just ‘active’ members (those making contributions or accruing benefits), but also deferred members and pensioner members. If they previously purchased a lifetime annuity from their pension, this also counts as being a member of a pension scheme.

A common misunderstanding of carry forward is that it can’t be used to carry forward unused tax relief. If your client wants to make use of carry forward using personal contributions, they must still have sufficient earnings in the tax year they are making the contribution to be eligible for tax relief.

Exceptions

There are also some circumstances where contributions won’t be counted towards the annual allowance. These are contributions made in the tax year where the member:

The second of these is notably stricter than the requirement to access a pension before the normal minimum pension age on ill health grounds.

If you are advising a client who is in serious ill-health, they should be aware that an additional contribution made within two years of death would need to be declared by the executors to HMRC (on form IHT409) and could be viewed as a transfer of value from the estate. This could prevent any IHT advantages of making the contribution.