One thing I find very difficult to understand with UK pensions is the tapered annual allowance.

Can you help explain this complex rule?

Podcast listener

Tom Selby, AJ Bell Senior Analyst says:

amount they can contribute to a pension each year without incurring tax charges is £40,000 – the ‘annual allowance’. Personal contributions are also limited to 100% of your UK earnings during the tax year.

There are two key exceptions to this. Firstly, where someone has flexibly accessed taxable income from their retirement pot the ‘money purchase annual allowance’, or MPAA, is triggered, reducing the maximum annual allowance from £40,000 to just £4,000.

You can read more about the MPAA here. 

Secondly, for very high earners the ‘tapered annual allowance’ may become a factor. Whether or not you’re affected by the taper will depend on two income measures – ‘threshold income’ and ‘adjusted income’.

Threshold income is broadly taxable income (so earnings plus investment income) minus personal pension contributions.

Adjusted income is taxable income (again earnings and investment income) plus employer contributions.

Threshold income also needs to include any salary sacrifice or flexible earnings arrangements set up after 8 July 2015, while taxable lump sum death benefits are deducted to reach both income measures.

If threshold income exceeds £200,000 and adjusted income exceeds £240,000, your annual allowance will be reduced by £1 for every £2 of adjusted income earned above £240,000. The lowest your annual allowance can be reduced to is £4,000 (for those with adjusted income of £312,000 or more). These limits apply in the 2020/21 tax year and going forward. From 2016/17 to 2019/20 the threshold income limit was £110,000 and the adjusted income limit £150,000, with a lowest possible annual allowance of £10,000.

One of the tricky things about the tapered annual allowance is that it can be hard to know exactly what your annual limit for the tax year will be. For example, lots of people have unpredictable hours or earn significant bonuses which make it difficult to know what their income will be, and therefore what pension contribution they can make without incurring tax charges.

An example
Let’s assess how the tapered annual allowance could affect someone. In 2020/21 Karen expects to earn £300,000 in salary and £20,000 from a rental property.

She will pay £15,000 in personal contributions to her workplace defined contribution pension, with another £15,000 contributed by her employer.

Assuming Karen’s income and pension contributions are what she expects:

Her threshold income will be: (£300,000 salary + £20,000 of rental income) - £15,000 personal pension contributions = £305,000

Her adjusted income will be: (£300,000 salary + £20,000 of rental income) + £15,000 employer pension contributions = £335,000.

As her threshold income is above £200,000 and adjusted income is above £240,000, the tapered annual allowanced will apply. Because her adjusted income is above £312,000, her annual allowance for 2020/21 will be £4,000.

If Karen makes total pension contributions of £30,000, she will therefore face an annual allowance charge on the £26,000 excess.

As she’s an additional-rate taxpayer the contribution would have benefitted from 45% tax relief, meaning the tax charge to recoup this relief will be 45% x £26,000 = £11,700.

DO YOU HAVE A QUESTION ON RETIREMENT ISSUES?

Send an email to editorial@sharesmagazine.co.uk with the words ‘Retirement question’ in the subject line. We’ll do our best to respond in a future edition of Shares.

Please note, we only provide information and we do not provide financial advice. If you’re unsure please consult a suitably qualified financial adviser. We cannot comment on individual investment portfolios.

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