How much can I contribute to my pension? - A guide to funding your pension (UK)
Tuesday 6th July, 2021
How much can you contribute to your pension each year? This is a crucial question, as knowing the answer will put you in a strong position to build your pension pot and take advantage of the fantastic tax reliefs on offer.
However, there are also many pitfalls and if you contribute too much to your pension, this can result in an unforeseen Annual Allowance tax charge. It is therefore very important that you have a broad understanding of the rules relating to pension contributions and what your options are.
The article below will explain the pension Annual Allowance, pension carry forward principles, The Tapered Annual Allowance for high earners, the Money Purchase Annual Allowance and the impact of exceeding your annual pension allowance. It will also cover how contributions are made and tax relief provided.
How much can I contribute to my pension?
It is amazing how many people don’t know the answer to this question, especially when you consider how important it actually is.
Part of the reason for this is that for so many years, retirees were able to retire and rely on the State Pension and Final Salary pension accrued during their career to support them during retirement. These would increase in line with inflation and there was no investment risk associated with the returns. The company/government would carry all the investment risk required to generate the retiree’s income. Provided you could live on your pension income at the beginning of retirement, then it was a pretty good bet that your pension would be sufficient to meet your needs throughout retirement.
However, people live far longer these days and the population of retired people is increasing while the population of working people is decreasing. This means that most companies have closed their final salary pension schemes and the nature of the State Pension will more than likely have to be overhauled at some point in the future, unless there is a massive demographic shift for some reason. I cannot imagine a world without a State Pension, but it seems almost inevitable that something will need to be done to make it more sustainable. When this happens, it will also have to balance the needs of the people going into care and the additional costs and burden this places on the state.
So, what has this got to do with pension contributions. Well, with a loss of retirement security as a result of the demise of final salary pensions, it means that we are going to have to shoulder far more of the burden of saving for our individual retirements.
A rough rule of thumb is that you need to save 25 times your expected retirement expenditure in order to have a reasonable retirement. So, if you are planning to live off £30,000 per year, then you need to save £750,000. If you draw 5% per annum from a £750,000 pot this would provide approximately £37,500 per year. Bearing in mind that 5% per annum is far in excess of most accepted safe withdrawal rates and that the £37,500 hasn’t yet been adjusted for inflation or tax, most of us are probably not on track to meet our goals.
This is born out by the fact that the average pension after a life time of saving is £61,897 (Telegraph – What is a good pension pot? – 04/01/2021).
I am told that with the new Auto Enrolment, there will be far less problems in the future and people will be better equipped to fund their own retirement. Let's review this assumption. According to the ONS, the average UK earnings for 2020 was £31,461 per year. Auto Enrolment requires 8% of your salary to be saved each year. Based on earnings of £31,461 per year, this amounts to monthly contributions of approximately £210 per month. If we assume a person saves consistently into their pension from the age of 18 to the age of 67 and receives a 5% annual return, then this will leave them with a pension pot at retirement of approximately £530,687. While this is below the 25 times expenditure suggested it is still a good pension pot.
Unfortunately, most people don’t save consistently into their pension for that amount of time and the majority of people are not overly keen on working until age 67. Furthermore, pension saving works like a barrel rolling down a hill. It starts slowly and reaches top speed close to the bottom. In other words, people tend to make the majority of their pension contributions in the later stages of their career.
If we are going to bear more responsibility for our retirement, then we need to be more aware of what our options are for funding our pensions. This task has however not been made any easier by constant government tinkering with allowances and contribution levels.
I have therefore put together the guide below to provide some basic guidance around how much you can contribute to your pension, how the contributions can be made, and how tax relief is applied.
How much can I contribute to my pension each year?
For the majority of people, the pension Annual Allowance is capped at the lesser of:
- 100% of relevant UK earnings
- £40,000 per year
The £40,000 refers to the maximum gross level (including tax relief) of contribution that can be made to the pension in any one year.
Relevant UK earnings broadly includes the following:
- employment income, such as: pay, wages, bonus, overtime, or commission
- income from a trade, profession or vocation
- income from a UK and/or EEA furnished holiday lettings business, which is
- chargeable under Part 3 ITTOIA 2005
- patent income
An individual with no relevant UK earnings can still make tax relievable pension contributions, but these are capped at £3,600 (£2,880 net).
Once the £40,000 Annual Allowance for the current year has been utilised, it is possible to carry forward unused Annual Allowance from the previous 3 tax years. It is therefore, theoretically possible to contribute £160,000 to a pension in one year, utilising the full current Annual Allowance, as well as the previous three year’s unused Annual Allowance. The individual making the contribution would need to have Relevant UK earnings of at least £160,000 to achieve this. In addition to this, they must have been a member of a UK registered pension over that period.
To understand how carry forward works, I have provided an example below.
Pension Carry Forward Example:
Sarah made a large contribution to her personal pension plan in tax year 2018/19, carrying forward some unused annual allowance from the 2017/18 tax year. It’s now tax year 2021/22 and she wants to know how much unused Annual Allowance she can carry forward because she’s planning on making another large personal contribution.
The table below set out her previous pension contributions and how much she can carry forward:
Based on the table of contributions above, she can make a contribution of up to £53,000 in tax year 2021/22 (£40,000 standard annual allowance for 2021/22 and £13,000 carry forward from 2020/21) without being subject to an Annual Allowance tax charge.
There are many other factors to be taken into account and it is important to take advice before calculating this yourself. However, the example above does demonstrate how this principle works.
The Tapered Annual Allowance
Some high earners will find their Annual Allowance reduced, if their adjusted annual income exceeds £240,000.
For every £2 of adjusted income over £240,000, an individual’s Annual Allowance is reduced by £1. The minimum Annual Allowance to which their income can be tapered is £4,000.
There are two tests to determine whether someone is affected by the Tapered Annual Allowance.
The first is a test of an individual’s Threshold Income. Threshold income consists of a number of elements including:
- salary, bonus,
- pension income (including state pension),
- taxable element of redundancy payments,
- taxable social security payments,
- trading profits,
- income from property (rental income),
- dividend income,
- onshore and offshore bond gains,
- taxable payment from a Purchased Life Annuity,
- interest from savings accounts held with banks, building societies, NS&I and Credit Unions,
- interest distributions from authorised unit trusts and open-ended investment companies,
- profit on government or company bonds which are issued at a discount or repayable at a premium and income from certain alternative finance arrangements etc
- less the amount of any taxable lump sum pension death benefits paid to the individual during the tax year that can be deducted from the threshold income.
If an individuals Threshold Income exceeds £200,000, you then move on to the second part of the test, which is a test of Adjusted Income to see if the individual's Annual Allowance will be tapered.
Adjusted Income is a very complex area and includes all taxable income, as well as employer pension contributions. Suffice to say, that if the Adjusted Income exceeds £240,000, then your Annual Allowance will be reduced by £1 for every £2 it exceeds the £240,000 threshold.
I think the key take away from this is that, if you have a total income around £200,000 per year, you should probably review any pension contributions you are making in order to ensure that you do not accidently trigger an Annual Allowance tax charge.
The Money Purchase Annual Allowance
There are situations where the maximum pension allowance can be reduced when you start taking your pension. These apply in cases where you draw out taxable pension income using either Flexi-Access drawdown or Uncrystallised Fund Pension Lump Sums (UFPLS).
The aim of these restrictions is to stop recycling of tax-free cash, where individuals withdraw tax free cash from the pension and reinvest it to get tax relief. In cases of Flexi-Access drawdown and UFPLS, as soon as taxable income is withdrawn from the pension, this triggers the Money Purchase Annual Allowance (MPAA), which reduces the Annual Allowance to £4,000 per annum.
With Flexi-Access Drawdown it is possible to take tax free cash from the pension, without withdrawing taxable income. In this situation the MPAA is not triggered.
The MPAA is also not triggered if:
- You take your tax-free cash and use the rest of the pension to purchase a lifetime annuity
- You use the small pots pension provisions to cash in a pension valued at less than £10,000
The MPAA also does not apply to pension contributions made to DB pension schemes.
What happens if I exceed my pension annual allowance?
If you exceed your available Annual Allowance within a tax year, then there will be an Annual Allowance tax charge due on the excess.
The excess amount over the available Annual Allowance is added to your earnings for the tax year to see which tax band (or bands) it falls into.
The earnings in this case are your 'net reduced income', which is your taxable income for the tax year after deducting personal allowances, gross pension contributions, allowable losses, gross charitable donations etc.
The charge is broadly:
- 45% on any of the excess amount that falls into the additional 45% income tax band;
- 40% on any of the excess amount that falls into the higher 40% income tax band; and
- 20% on any of the excess amount that falls into the basic 20% income tax band
How to make pension contributions
When you make pension contributions, you basically have two options:
- You can make the pension contributions yourself out of your taxed income (relief at source method)
- You can ask your employer to contribute to your pension from out of your pre-tax salary (net pay method)
Relief at source
With this option relief is claimed in two tranches:
Standard rate taxpayers:
The pension member pays the contribution out of their taxed income. If they pay £100 into the pension, the scheme administrator will claim 20% tax relief from HMRC, which will be added to the contribution. £100/0.80 = £125. Based on this, the tax relief will be £25. The gross contribution will therefore be £125.
Higher rate taxpayers:
For higher rate taxpayers, they can claim an additional 20% tax relief, as their upper rate of income tax is 40%. They have received 20% reclaimed through the pension. They will now have to claim a further 20% via their tax return or ask that their tax code be adjusted, so that less tax is taken from their pay via PAYE.
If the tax relief is claimed via the tax return, the relief is provided by increasing the members basic rate tax band by the gross amount of the contribution. In this case the basic rate band would be extended by £125.
Without the extension of the basic rate band, their tax liability on this would be £50 (£125 x 40%). However, by extending the basic rate band, the tax rate is dropped to 20%, thus halving the amount of the tax liability to £25 (£125 x 20%). In this way, the higher rate taxpayer has received £25 tax relief added to his pension contribution and £25 tax relief through their tax return, which amounts to a total tax relief of £50 or 40%.
The main problem with this approach is that many higher rate taxpayers forget to reclaim the tax through their tax return. Fortunately, there is a time limit of four years to claim back any tax relief from HMRC. A claim must be made within four years of the end of the tax year that a member is claiming for.
Net pay method
With this method, your employer pays the contribution on your behalf from your pre-tax pay. There is no tax relief to claim, as the contribution has been made before any tax is paid. Therefore, if your employer contributes £2,000 to your pension, the gross contribution is £2,000.
In many ways this is the best way to make contributions, as there are no National Insurance contributions for either the employee or the employer. In reality, you can use this method to increase your own pension contributions by sacrificing part of your salary in return for increased pension contributions from your employer.
Once you accept a salary sacrifice, your overall pay is lower, so you pay less tax and National Insurance. Your employer may also agree to pay their savings on National Insurance into your pension as well, further increasing your pension contributions. If done correctly, you can increase your pension savings without seeing a fall in your actual take home income, despite giving up some of your pre-tax pay.
This is a complex area and needs a bit of advice to ensure that it is absolutely suitable, but has the potential to increase pension contributions without losing income.
As you can see, this is a very complex area, but if utilised properly it can provide real benefits. It really makes sense to take some advice from your financial adviser to make sure that you:
- Are maximising pension contributions and tax reliefs
- Haven’t accidently exceeded your annual allowance
- Aren’t affected by the Tapered Annual Allowance
- Haven’t triggered the Money Purchase Annual Allowance
- You are on track for your retirement goals
If you have any questions about these topics, please don’t hesitate to give us a call.