Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
Beware the pension tax taper trap
The Government has had an insatiable appetite for tinkering with pension tax perks.
George Osborne when he was chancellor continually hacked away at the lifetime allowance – the limit the Government sets on how much you can have saved in all your pensions. It went from £1.8m to £1m.
He also oversaw two reductions in the annual allowance – the amount you can save in a pension tax-free each year. The allowance currently stands at £40,000 for most people.
Cuts cuts cuts
There are two scenarios in which your annual allowance will be lower than £40,000.
A separate Money Purchase Annual Allowance (MPAA) was introduced by the Government to stop savers ‘recycling’ cash through their pension.
The MPAA means anyone who has accessed their pension flexibly from age 55 is subject to a reduced annual allowance of £10,000.
The Government has proposed reducing this allowance to just £4,000 from April this year.
However, it is the devilishly complex pensions tax ‘taper’ – a third limit on annual pension saving – I want to focus on here.
Will you be affected by the taper?
Do you have total ‘adjusted income’ – which includes all income and employer pension contributions – of £150,000 or more? Are you planning on paying into your pension between now and the end of the tax year in April? If so, the taper might affect you.
Under rules set out by Government, for every £2 of adjusted income above £150,000 your annual allowance will be reduced by £1, right down to a minimum of £10,000 for anyone with adjusted income above £210,000.
Any contributions over your annual allowance will be hit with a tax charge – unless you have ‘carry forward’ available from previous years.
Carry forward rules allow you to use any unused allowances from the previous three tax years to minimise your tax bill.
It’s worth noting that if your ‘threshold income’ – that is your total income less any personal pension contributions – is less than £110,000, you will not normally be subject to the tapered annual allowance.
Talk to a regulated financial adviser if you are unsure about your personal situation.
How this works in practice
Georgina has salary of £130,000 and investment income of £10,000 in the 2016/17 tax year. Her employer makes a £30,000 contribution and she personally makes a contribution of £10,000.
Her adjusted income is £170,000 (£140,000 income chargeable to income tax + £30,000 employer pension contribution).
Georgina’s threshold income is £130,000 (£140,000 income minus £10,000 personal contribution).
As both her threshold and adjusted income are above the Government limits, Georgina is subject to the taper and her annual allowance is reduced by £10,000 to £30,000.
As her total pension contributions were £40,000, she will be subject to a tax charge on the £10,000 excess, unless she has carry forward available.
Senior analyst, AJ Bell