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.
Discover how much you can stick in a pension and still get government cash
The government operates generous incentives to encourage people to use a pension to save for their retirement, but it is worth bearing in mind these incentives are subject to a few controls and limits.
WHAT IS THE ANNUAL ALLOWANCE FOR PENSIONS?
The pensions annual allowance is the amount of money that can be saved across all your pensions each year before a tax charge applies. This includes money you save personally, any tax relief claimed by your pension provider from HMRC for you, as well as what is saved into your pensions on your behalf, by an employer or by a third party.
The standard annual allowance is set at £40,000 for the current tax year. However, for some people it will be lower, and for some higher, as we’ll come onto.
There is nothing to stop you having total pension contributions over the annual allowance, but anything over your available annual allowance will be subject to a tax charge.
HOW DOES THE ANNUAL ALLOWANCE WORK FOR DEFINED BENEFIT (DB) PENSIONS?
The value paid to most schemes is easy to work out – it is simply the total amount that has been paid in.
For defined benefit pensions, there is an additional calculation that works out the capital value of the increase in your pension and tax free cash benefits over the year. This value is then added to contributions made to other scheme types to give you your total pension input. Your scheme administrator will give you details of value of the increase (also known as the defined benefit pension input amount) after the end of the tax year.
If you have been a deferred member of a defined benefit scheme for a whole tax year, then you will normally have no pension input under this calculation for the tax year.
CAN I USE ANY ANNUAL ALLOWANCE FROM A PREVIOUS YEAR?
You can carry forward unused annual allowance from the previous three full tax years, providing you were a member of any UK pension scheme for those past years. This can be particularly useful if your earnings or self-employed trading profits vary from one year to the next.
‘Carry forward’ only relates to unused annual allowances from the previous three years. You cannot carry forward unused tax relief from any year before that.
Carry forward for contributions to defined contribution schemes (SIPPs and personal pensions) is not available if you have already accessed your pension fund to provide you with a flexible income.
WHAT IS THE TAPERED ANNUAL ALLOWANCE?
The annual allowance taper reduces the annual allowance applies for savers who have both: an ‘adjusted income’ of more than £240,000; and a ‘threshold income’ of £200,000.
It is important to note that it is not just earnings that count towards these limits, any income from investments such as dividends, rental income or interest is included too. Adjusted income also includes all pension contributions (including any emplyer contributions), while threshold income excludes pension contributions.
If you are subject to the taper, your annual allowance is reduced by £1 for every £2 of adjusted income you have above £240,000, to a minimum allowance of £4,000.
The income limits were lower in previous tax years – the adjusted income was £150,000 and the threshold income was £110,000 for the tax years 2016/17 to 2019/20 (inclusive)
HOW IT WORKS IN PRACTICE
Saira’s adjusted income for the year is £300,000 and her threshold income is £250,000.
Her adjusted income is £60,000 over the limit and her annual allowance will be reduced by the taper by £30,000, to £10,000.
David’s adjusted income is £250,000 but his threshold income is £195,000. He is not subject to the annual allowance taper.
As the calculation is carried out each tax year, you could find you are subject to the taper in one year but not another. This might be the case if your income was above the previous limits but is now below the new limits that were increased in 2020/21.
You can still make use of carry forward if you are subject to the tapered annual allowance in a year. Your available annual allowance will be calculated in relation to whatever your unused annual allowance was for the relevant year.
The unused annual allowance available to carry forward from a tax year in which the taper applied will therefore be the balance of the tapered amount from that year.
The rules surrounding the tapered annual allowance and the adjusted income calculations can be very complex. You should obtain professional financial and tax advice if you are unsure.
WHAT IS THE MONEY PURCHASE ANNUAL ALLOWANCE? AND CAN IT BE AVOIDED?
The money purchase annual allowance (MPAA) applies to savers who have accessed their pensions to provide them with a flexible income or taxable pension lump sums. It is currently set at £4,000 per tax year.
The MPAA is not triggered if you only take your tax free cash and no income.
Once the MPAA has been triggered, a tax charge will apply if more than £4,000 is paid into your money purchase pensions. Money purchase pensions include SIPPs, personal pensions and some workplace pension schemes. It does not apply to defined benefit schemes.
If you have triggered the MPAA, then you are not permitted to use carry forward from a previous tax year to offset contributions of over £4,000 to your money purchase pensions.
Your pension provider will tell you within 31 days if you have triggered the MPAA for the first time.
They will also tell any new pension provider you transfer your pension to, but if you join a new scheme without making a transfer, it is your responsibility to tell them you are subject to the MPAA within 91 days or you could face a penalty from HMRC.
I THINK I HAVE EXCEEDED MY ANNUAL ALLOWANCE – HOW MUCH TAX WILL I HAVE TO PAY?
If you have exceeded your annual allowance and have no carry forward available, then the excess contributions amount will be subject to a tax charge.
The level of the tax charge will be determined by your marginal rate of income tax – the excess contribution over your applicable allowance will be added to your earned income to determine the income tax band (or bands) it falls into.
The annual allowance tax charge is normally collected through self-assessment. If you will have an annual allowance tax charge to pay but you do not normally complete a self-assessment tax return then you must contact HMRC.
It might be possible for the tax charges to be paid from your pension, meaning you do not have to find the money to do so via self-assessment. This is a known as ‘scheme pays’. Pension schemes can choose to offer this facility, or under very specific circumstances they can be compelled to do so.
SO HOW MUCH CAN I SAVE IN A PENSION EACH YEAR?
This should be a straightforward question, but the reality can be a little more complicated.
In this article we have just looked at the annual allowance. If you are making personal contributions, you will also need to consider the rules around tax relief.
You can find out more about tax relief and how it operates in our recent article, but in short you cannot get tax relief on contributions exceeding your UK taxable earnings, and pension providers will not typically accept contributions that aren’t eligible for tax relief.
Therefore, for some people the annual allowance will be the limiting factor. For others, it will be the rules on tax relief.
If you are considering making large contributions it may be worth speaking to a regulated financial adviser.