The 6th of April 2006 was a magical and meaningful day for every single person in the UK. It was a day that introduced major changes that would impact the whole UK population. It was a sunny Thursday and ‘Crazy’ by Gnarls Barkley was taking over the radio-waves – do you remember it?
“No!” Is the response we expect – and rightly so! But this was an important day, known to the financial services world as ‘A-Day’ – heralded as the introduction of ‘Pension simplification’.
Amongst other major changes to Pensions, the Annual Allowance was introduced.
The Annual Allowance limits the amount of tax relief a UK resident can gain when contributing to their Pension. After years of political tinkering since ‘Pension simplification’ in 2006, the limitations for building your Pension savings are no longer ‘simple’. In fact the current UK legislation presents consumers with a myriad of variables at a time when important decisions must be made in order to maximise tax-efficient Pension savings for retirement.
Personal Pension Contributions & Tax Relief:
- Today, a UK resident can personally fund up to £40,000 to Pensions each tax year and benefit from tax relief.
- As you gain 20% tax relief when you contribute, you need to personally invest 80%.
- A £32,000 personal Pension contribution receives a 25% top-up of £8,000 from the government (thank you HMRC!)
- When making a personal contribution, your Pension provider claims 20% tax relief for you, regardless of your personal tax rate.
- If you are a a higher-rate or additional-rate taxpayer then you can claim further tax relief of either 20% or 25% through your self assessment. This mechanism means that higher-rate taxpayers can get £1 in to a Pension at a ‘real cost’ of 60p and for additional-rate taxpayers, the ‘real cost’ is just 55p.
Carrying Forward Unused Allowances:
- You can also contribute to fund any ‘unused allowances’ from the previous three tax years, this is known as ‘carry forward’.
- The maximum gross contribution in 2019/20 is therefore £160,000 for a saver who hasn’t contributed to a Pension since the 6th April 2016.
- Importantly, to carry forward unused allowances from previous years, you must have had a Pension product open in the previous tax year but do not need to have made contributions.
Lower & Upper Limits for Pension Tax Relief:
- Lower Limit: Everybody in the UK can save £3,600 to their Pension each tax year, regardless of income. This includes stay-at-home parents, those happily retired and even children!
- For this minimum amount of pension savings, you gain 20% tax relief.
- So by investing £2,880, you receive £720 tax relief and reach the £3,600.
- Upper Limit: Pension contributions above £3,600 that qualify for tax relief are limited to 100% of your ‘UK relevant earnings’. This means that you can’t gain more tax relief from Pension contributions than the income tax that you paid in the same tax year.
- Rental income or dividends from investments do not count as ‘UK relevant earnings’.
- Example: If salary and bonus total £90,000 and you have contributed £10,000pa over the last three years.
- Following the ‘carry forward’ logic above, you could contribute £130,000 to ‘carry forward’ unused allowances from the three previous years
- However you are restricted to a maximum £90,000 tax-relievable contribution, as this 100% of ‘UK relevant earnings’.
Annual Allowance for Business Owners:
- If you run your own Limited Company, you can choose to make employer contributions which are not limited by the ‘100% of UK earnings’ rule.
- The Pension provider will not claim the usual 20% tax relief but as the Pension contribution is an allowable business expense, your business reduces its taxable profits in the company year of the contribution. This creates a Corporation Tax saving within the business in addition to the personal tax saving you have made by not withdrawing the funds as a salary or dividend.
Annual Allowance for High Earners:
- HMRC deems anybody who has total income (including rental income, dividends from investments and company Pension contributions) of more than £150,000pa to be an ‘ultra-high-earner’.
- The annual allowance reduces from £40,000 for the tax year if you are an ‘ultra-high-earner’. This can be tricky, as you may not know your total earnings at the start of a tax year when you start your monthly Pension contributions.
- The allowance tapers slowly on a ‘£1 for every £2’ basis to the minimum allowance of £10,000pa. The maximum tapered allowance of £10,000 applies to anybody with income greater than £210,000, from all sources.
Final Salary Pensions
- The calculation method for Annual Allowance is very different for members of Final Salary Pensions. Instead of simply assessing the amount that has been contributed, the members deemed contribution is based on how much their Pension entitlement has increased over the last 12 months.
- The amount tested against the Annual Allowance is called the Pension Input Amount and it is not simple to calculate.
- Thankfully this should be calculated for the member by the scheme and confirmed in writing each year but regrettably, it is hard to control or plan for. As a result, any significant pay rises can produce a bump in the Pension Input Amount and a surprise Annual Allowance tax charge.
Later Life Pension Planning:
- Once you reach age 75, the Annual Allowance becomes irrelevant as you can no longer gain tax relief on Pension contributions.
ONE MORE THING…
Money Purchase Annual Allowance
The Money Purchase Annual Allowance (MPAA) is possibly the single largest trap in the UK tax system today. Nothing else quite compares to the MPAA as it has such wide reach and very low consumer awareness. Triggering the MPAA is inevitable but triggering it too soon is irreversible and can have an extremely detrimental long-term impact.
Like a well concealed bear trap hidden amongst foliage, the MPAA is a tax-trap set by HMRC that waits for unadvised Pension savers to fall into its hands.
When you first withdraw taxable income from your Pension after age 55 using ‘flexible access’ (the new default withdrawal method for most Personal pensions!), you trigger the MPAA.
From this day onwards, any further Pension contributions are significantly limited to £4,000pa. To worsen the impact, you also immediately lose the ability to ‘carry forward’ unused pension allowances from previous years.
The Money Purchase Annual Allowance is designed to stop Pension savers from withdrawing Pension funds and then re-investing the same funds back in to their Pension, gaining further tax relief. Although this makes perfect sense as a concept, it can cause far bigger issues, for example:
The Impact of the MPAA Trap, Example A
A working parent reaches age 55 and receives a letter from a pension provider, letting her know that she can now access a forgotten £12,000 Pension pot, accrued at a past employment. As the funds had been forgotten, the letter is a nice surprise for the parent, who fills in the form to withdraw the funds to book a holiday and buy her daughter’s first car. Until now, the parent was earning £50,000pa and had been contributing 10% of her salary to her workplace pension, which her employer kindly matched – a total annual contribution of £10,000pa. By helping her daughter, the parent has inadvertently triggered the MPAA. Without realising this, she continues to contribute for a further two years before reading about the MPAA. As she had contributed £10,000pa for two further years after triggering the Money Purchase Annual Allowance, of £4,000pa, she has over-contributed by £12,000. The parent would now need to pay an Annual Allowance Tax Charge of £4,800 (40%) by self assessment and immediately reduce her future pension savings – costing tax relief in the future.
The Impact of the MPAA Trap, Example B
A successful self-employed physio takes a break from work at age 50 to care for their ill parents. Unable to work for five years, the physio accrues personal debts to fund their families lifestyle, confident that they will be able to return to work and rebuild their savings. Shortly after their parents pass away, the physio returns to work and turns 55 years old. They decide to access their pension to repay their credit card debts and avoid the harsh 18% interest rate. By flexibly accessing their pension, the physio immediately limits future pension contributions to £4,000. This removes the physio’s only method of tax-relievable savings and results in all income being taxed heavily whilst they work to rebuild the families finances.
By now, you’ve probably realised why we have posted this Blog with an image of a Maze! Navigating the journey to retirement is difficult and the Annual Allowance is one example of the tax considerations when trying to plan for your future.
How can we help?
If you are an existing client reading this, you can relax.
If you are not a client but feel that you should seek advice after reading this, please contact us. We can setup a call for you with one of our Financial Planners to explore your current position and explain how our services can help you.
For our Individual Clients, we:
- Help company directors to structure their income and make best use of Pension allowances.
- Complete Carry Forwards calculations so that we always know how much a client could maximum fund to their pension in the current tax year.
- Consider all of the different methods of pension access in retirement, including those which do not trigger the MPAA.
- Highlight Annual Allowance issues in advance for clients who are impacted by the tapered annual allowance. We carefully plan contributions to maximise tax relief and avoid annual allowance tax charges.
- Assist clients to notify all pension providers when they first trigger the MPAA.
- If it may be beneficial in the future, we will open a personal Pension product if a client doesn’t already have one, to start accruing ‘unused’ allowances for future Carry Forward.
- Advise clients to slowly accrue Pension savings over time, to avoid needing to suddenly maximum fund pensions in the later stages of their working career.
- Help clients earning more than £150,000 to negotiate additional pay or benefits in lieu of employer Pension contributions if those contributions would otherwise be above their tapered annual allowance.
- Enable parents and grandparents to contribute £2,880 to Pensions for their children/grandchildren. Thanks to compound growth throughout the child’s lifetime, the amount that is contributed now will continue to grow to a meaningful sum.
For our Enterprise Clients, we:
- Include updates and guidance on how best to plan for the annual allowance in our annual workplace presentations to employees.
- Provide carry forward calculations for employees who are contributing larger amounts to their pension and need to stay within limits.
- Provide tapered annual allowance calculations for ‘ultra-high-earning’ employees who are impacted by reductions to their allowances.
- Encourage businesses to run a ‘Salary Exchange’ pension scheme, which simplifies tax reclaims for all employees.
- Guide employees to bring their total gross income below certain thresholds where other benefits may be lost, such as Child Benefit and the Personal Allowance.
Click HERE to read ‘Pension Allowances Part 2: Lifetime Allowance’
Published in January 2020.
The content of this blog post is based on our current understanding of UK legislation and applies to the 2019/20 tax year. This article should in no way be considered as personal advice.
If you have any questions whatsoever, please contact us: firstname.lastname@example.org