Pensions and tax
The annual allowance
The annual allowance is a limit on the amount that can be contributed to your pension each year, while still receiving tax relief. It's based on your earnings for the year and is capped at £40,000.
What is the annual allowance?
The annual allowance is a limit to the total amount of contributions that can be paid to defined contribution pension schemes and the total amount of benefits that you can build up in defined benefit pension scheme each year, for tax relief purposes. The annual allowance is currently capped at £40,000 although a lower limit of £4,000 may apply if you have already started accessing your pension. The annual allowance applies across all of the schemes you belong to, it’s not a ‘per scheme’ limit and includes all of the contributions that you or your employer pay or anyone else who pays on your behalf.
If you exceed the allowance
If you exceed the annual allowance in a year, you won't receive tax relief on any contributions you paid that exceed the limit and you will be faced with an annual allowance charge.
The annual allowance charge will be added to the rest of your taxable income for the tax year in question when determining your tax liability. Alternatively, if the annual allowance charge is more than £2,000, you can ask your pension scheme to pay the charge from your benefits. This means your pension scheme benefits would be reduced.
Unless you have a money purchase annual allowance (MPAA), you may be able to bring forward any unused annual allowances from the previous three tax years, to either reduce your annual allowance charge to a lower amount or reduce the annual allowance charge completely.
Your pension provider or scheme administrator should be able to give you your pension input amount for that scheme. This refers to the amount of contributions or value of accrued benefits during the pension input period. If you think that you may be getting close to your annual allowance, or may have exceeded it, you may wish to consider taking advice from a regulated financial adviser.
Changes to the annual allowance
The Money Purchase Annual Allowance (MPAA)
The Money Purchase Annual Allowance was introduced on 6th April 2015 and was set at £10,000 gross p.a. The government has now reduced the MPAA to £4,000 gross p.a. which applies to contributions made from 6th April 2017.
If you have taken flexible benefits which include income, such as an ‘Uncrystallised Funds Pension Lump Sum (UFPLS)’ or flexi-access drawdown with income, and you want to continue paying contributions to a defined contribution pension scheme, you will have a reduced annual allowance of £4,000 p.a towards your defined contribution benefits. The reduced allowance will apply if you have withdrawn more than the 25% tax free pension commencement lump sum (PCLS). The reduced amount is known as the ‘money purchase annual allowance' (MPAA) and includes both your own contribution and any other contribution paid on your behalf, such as an employer or a third party. You cannot bring forward any unused annual allowances from the previous three tax years to warrant a higher contribution than £4,000 towards your defined contribution benefits.
The money purchase annual allowance will only start to apply from the day after you have taken flexible benefits and so any previous savings are not affected.
The Tapered Annual Allowance
The tapered annual allowance came into force as of 6 April 2016 for high earners. For every £2 of income above £150,000 per annum, £1 of annual allowance will be lost. The maximum reduction will be £30,000 meaning that anyone earning over £210,000 will have their annual allowance capped at £10,000.
An income floor will mean the taper will not apply unless the individual's income excluding pension contributions exceeds £110,000 (referred to as their “threshold income”). We have more detail on this in our Spotlight on End of Year Tax Planning.
Calculating the value of benefits built up in a defined benefit pension scheme
If you’re a member of a defined benefit pension scheme, the increase in the value of your retirement benefits each year is used to calculate how much of your annual allowance the scheme uses. The calculation can be complex and you may wish to ask your scheme administrator to tell you whether you’re likely to be affected. If you have a significant salary increase in a particular year you may be at risk of exceeding the annual allowance. We give some general guidance on how to calculate pension savings into a defined benefit pension, alongside a worked example, below:
To calculate the amount of savings you need to work out the opening value, the closing value and then the difference between the two amounts.
Opening value: Find the total amount of annual pension built up immediately prior to the start of the year/pension input period and multiply this amount by 16. Next add any lump sum entitlement built up in the pension plan as of the same valuation date. You then have to increase the pension by inflation using the CPI figure for September prior to your valuation date to get your opening value.
Closing value: Find the total amount of annual pension built up by the end of the year/pension input period and multiply this amount by a flat 16. Next add any lump sum entitlement built up in the pension plan as of the same valuation date. There is no enhancement for inflation in this calculation, but you may need to make adjustments to this figure if there have been any transfers out/in that need to be taken into account.
Pension savings to be tested: Simply take away the opening value from the closing value to work out the difference between the two figures and therefore the amount that has been saved in to your defined benefit pension on your behalf.
We have included some worked examples from HMRC's website below:
Example 1: 1/60th accrual rate, no separate lump sum entitlement
Tina is a member of a final salary scheme giving her a pension of 1/60th pensionable pay for each year of service. At the start of the pension input period Tina’s pensionable pay is £80,000 and she has 31 years pensionable service. At the end of the pension input period Tina’s pensionable pay has risen by 5 per cent to £84,000 with 32 years pensionable service.
Tina does not have any other pension arrangement.
Tina’s total pension input amount is the increase in the value of her pension saving over the year. This is the difference between the opening value and the closing value of her promised benefits.
Tina’s opening value is calculated as:
find amount of annual pension
31/60 x £80,000 = £41,333.33 multiply annual rate of pension by flat factor of 16
£41,333.33 x 16 = £661,333.28 increase by CPI (for the purpose of this example, 3 per cent)
£661,333.28 x 1.03 = £681,173.27 Tina’s opening value is £681,173.27.
Tina’s closing value is calculated as:
find amount of annual pension
32/60 x £84,000 = £44,800 multiply annual rate of pension by flat factor of 16
£44,800 x 16 = £716,800 Tina’s closing value is £716,800.
The difference between the closing value and the opening value is £35,626.73. Tina’s pension input amount is £35,626.73.
Example 2: 1/80th pension + 3/80th lump sum
Asif belongs to a pension scheme that gives him benefits of:
a pension of 1/80th final salary for each year of pensionable service a separate lump sum (i.e. not by commutation of pension) of three times his pension At the start of his pension input period Asif’s pay is £60,000 and he has been a member of the scheme for 14 years. At the end of his pension input period Asif’s ‘final pay’ has increased by 5 per cent to £63,000 and he has 15 years scheme membership.
Asif does not have any other pension arrangement.
At the start of Asif’s pension input period the value of his benefits (the opening value) is calculated as:
find amount of annual pension
14/80 x £60,000 = £10,500 multiply annual rate of pension by flat factor of 16
£10,500 x 16 = £168,000 add amount of separate lump sum
£168,000 + (3 x £10,500) = £199,500 increase by CPI (for the purpose of this example, 3 per cent)
£199,500 x 1.03 = £205,485 Asif’s opening value is £205,485.
At the end of Asif’s pension input period the value of his benefits (the closing value) is calculated as:
find amount of annual pension
15/80 x £63,000 = £11,812.50 multiply annual rate of pension by flat factor of 16
£11,812.50 x 16 = £189,000 add amount of separate lump sum
£189,000+ (3 x £11,812.50) = £224,437.50 Asif’s closing value is £224,437.50.
The increase in Asif’s benefits over the pension input period is £18,952.50. Asif’s pension input amount is £18,952.50.
Asif’s total pension input amount for the tax year is also £18,952.50, as he does not have any other arrangements to take into account for the same year.
Receiving tax relief on pension contributions
You can only receive tax relief on contributions that you pay into your pension scheme(s) that don’t exceed your UK net relevant earnings in the tax year that you pay them.
If you’re considering paying contributions that will exceed your annual allowance in a year, then unless you have a money purchase annual allowance (MPAA), you may be able to carry forward unused allowance from the previous three tax years to help increase your tax relief up to your earnings. Your pension provider can help you with this or you can talk to one of our team for more information.
Where can I find out more?
If you need more information, please contact us. A pension specialist from our team will be happy to help with whatever pensions-related question you have. Our help is always free.