Why the tapered annual allowance could cost more than you think

Published by Bhargaw Buddhdev on

High earners could find themselves footing large tax bills when a series of changes to pensions tax relief are implemented in April 2016.

The level of relief, known as the annual allowance (AA), is to fall dramatically – potentially reducing from its current £40,000 limit to £10,000 for some of the highest paid executives (and with hefty tax charges should these limits be breached).

Who will be affected?

The changes affect individuals with a threshold income greater than £110,000. Threshold income is broadly total taxable income from all sources less pension contributions (i.e. it takes into account more than just salary, covering all taxable earnings, including savings interest, shares dividend and even income from property rental).

If threshold income exceeds £110,000, individuals will need to calculate their ‘adjusted income’ for the year. Adjusted income includes all threshold income as well as the total amount of pension contributions or accrual. If this is between £150,000 and £210,000, the individual’s AA will be reduced on a sliding scale from 6 April 2016. The reduction – or taper – to the AA will be £1 for every £2 of adjusted income over £150,000, (with a maximum AA reduction of £30,000 for income over £210,000). This will impact not only private sector executives, but potentially senior public sector management, doctors and high level civil servants.

Even those earning less than £150,000 may find themselves affected given adjusted income takes into account more than just salary, and the value of pension contributions is also included. If you have long service in a final salary pension, your adjusted income could be much higher than you realise.

"This will impact not only private sector executives, but potentially senior public sector management, doctors and high level civil servants."

Maximising tax-free pension contributions

One difficulty is that no-one knows the exact amount of their adjusted income until the end of the tax year. Maximising tax-free pension contributions becomes more difficult because the amount of available tax relief depends on total earnings over the tax year. Should you exceed the AA, excess contributions will be taxed at your marginal rate of tax. This could catch out anybody, but the self-employed and those with unpredictable income will need to be particularly cautious.

It may be sensible to move other sources of income, for example a rental property, into the name of a spouse or partner to reduce your threshold (and therefore adjusted) income. But ultimately, you are responsible for personal taxation and while your employer may be offering help during this period of change, you may need additional support from a financial adviser who is qualified in these matters.

The key is to establish whether you will be affected. If you have a threshold income of £110,000 or less then you will not be affected. This is most likely to be the case if you don’t earn a high salary or have extensive investments; however, you should check your position.

Carry forward

You can carry forward any unused allowances from the previous three tax years in order to make additional tax-free pension savings. This may be particularly useful for those affected by the taper.

To establish how much allowance you can carry forward, you need to work out how much you’ve previously contributed. However, transitional rules to align pension input periods (PIPs) (the period over which contributions are measured for comparison with the AA) with tax years, means it’s not as simple as looking at your net contributions. It is probably simplest to request details from your pension administrator. You should also consider taking professional advice when making decisions regarding your pension benefits.

Be LTA wise

Even if you are not affected by the tapering of the AA, it is also wise to see where you are towards the lifetime allowance (LTA). This is the total value of savings in all registered pension schemes that you can build up during your lifetime without incurring a LTA tax charge, and is set at £1.25 million for the current tax year (2015/16). From 6 April 2016, the LTA will reduce to £1 million and is therefore likely to impact an increasing number of individuals going forward. There are protections for those who are approaching or have reached the LTA.

Due to the complexity surrounding the tapered AA, it would be unwise to leave the above considerations until the last minute. There is likely to be something of an avalanche of last minute queries as the end of the tax year approaches. 

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