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.
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.
The basics of pension allowances
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 £10,000 in two separate scenarios. It’s a drop that could mean the loss of £20,000 worth of ‘free money’ every year.
What are the threats to your pension allowances?
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.
Threat 1: drawing your pension (the money purchase annual allowance)
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 However, if you have begun to take flexible benefits (e.g. drawdown) or have withdrawn more than the 25 per cent tax free lump sum, your annual allowance reduces to £10,000 per year, and is then called the money purchase annual allowance (MPAA).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 ever be in a position to pay more than £10,000 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 £10,000.
Useful tips to preserve your pension allowance
- Plan ahead
If you want to make some large pension contributions towards the end of your working life, plan when this will happen and delay taking your pension until afterwards.
- Talk to an independent financial adviser
Make your retirement plan with the help of a financial adviser and you’ll maximise the benefits of pension freedom while removing the risks of silly mistakes like losing most of your annual allowance too soon.
Threat 2: passing the adjusted income threshold (the annual allowance taper)
If your earnings are above £150,000, your annual allowance 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.
What if I exceed my annual allowance?
If you pay in more than your annual allowance, you’ll receive no tax relief on the excess – and also you’ll have to pay a penalty, which in the worst cases could run into thousands of pounds. The size of the charge will depend on your taxable income and by how much you’ve exceeded the allowance.
What can I do? Some useful tips
- Talk to your employer
If your income is in the region of £100,000 or higher, then you are nearing the ‘taper zone’. Have a conversation with your employer about both your salary and the pension contributions that they make, to see if these may lift you above the threshold, and if it’s no longer worth remaining in their pension scheme, talking to an independent financial adviser who may be able to suggest alternative benefits.
- Use as much as you can of your current annual allowance
If you’re a higher earner and have any unused annual allowance from the current year or the past three years, now is the time to make the most of it. The potential gains through tax relief mean it’s worth paying in as much as you can afford before the new limits come in.
- Redistribute your income where practicable
If income from assets such as investments or property might lift you into the taper zone, see if you can transfer ownership to your spouse.
- Consult an independent financial adviser
Your financial adviser will have the best grasp of all your income and outgoings, and should be best placed to predict if you will be affected by the taper, and to offer practical solutions. This is one area where bespoke independent financial advice really is essential, as everyone’s circumstances will be different.
A version of this article was previously published by Unbiased on 8th May 2019