Should I keep funding my pension, if the contributions will exceed my pension annual allowance?
Friday 26th August, 2022
The importance of pensions as a tax efficient vehicle for funding retirement cannot be understated. However, more and more people are being caught by provisions brought in by the government that limit the amount individuals can save into their pensions each year.
In the past, this may have been dismissed as a problem for the wealthy, that does not affect the average person in the street. While this may have been the case, when these restrictions were first brought in, new changes to how the annual allowance works, means that even people on modest incomes can end up triggering an annual allowance charge. More and more often I am approached by clients of all income levels who have inadvertently creates a tax liability by exceeding their adjusted annual allowance.
In the article below I will briefly look at the annual allowance and how it works. I will also cover the main restrictions and their implications, before moving on to look at whether it is worth continuing to fund your pension, despite triggering the annual allowance charge.
Who remembers those halcyon days of 2010/11, when the annual pension allowance was a heady £255,000? If you were a high earner, then you could really go to town on contributing to your pension. It was like it was raining pension tax relief.
And then on 06/04/2011, it all abruptly ended. The annual allowance was butchered down to £50,000, and the concept of pension simplification took one step closer to the abys.
Now, in reality, these changes impacted a tiny percentage of people. There were those people in final salary schemes who got sudden salary increases, resulting in a spike in their final salary income, resulting in the pension contributions for the year in question exceeding the annual pension allowance. There were those who had expected to spend there last few years of employment super-funding their pensions, in order to make up for years of neglect and suddenly found their ability to do that curtailed. There were the high earners who were using chunky bonus checks to make sizeable tax relieved contributions into their pensions each year.
However, the majority of people remained completely and blissfully unaffected by these changes in the annual allowance provisions.
Unfortunately, there have been a number of changes introduced since then that have meant more and more people are exceeding their annual allowance provisions and questioning whether it is worth still funding pensions if they are likely to trigger an annual allowance charge.
In the following article, I will look at:
- How the annual allowance works
- What the changes to the annual allowance are and what their impact is
- Whether it is worthwhile continuing to fund your pension, if a meaningful level of pension contribution means you will trigger a tax charge
The annual allowance
In a nutshell, the pension annual allowance is a limit on the the amount of tax relieved pension contributions that can be made for an individual in each tax year.
The annual allowance is the lower of:
- 100% of an individual’s net relevant UK earnings
There is the option to carry forward unused annual allowance from the last 3 tax years, provided you have first utilised the annual allowance available in the current tax year. There are a few requirements that have to be met to do this, but it is a useful tool if you suddenly have a windfall and wish to make a larger than normal contribution to your pension.
If a pension member does exceed the annual allowance and they have no carry forward available against which to offset the excess, then they will be liable for a tax charge on the excess at their marginal tax rate. In truth, I am not against this, and as tax charges go, it is not massively onerous. All that is being reclaimed is tax relief that the pension member was not entitled to. It is therefore not punitive, but rather focussed on reclaiming tax relief that the member was not entitled to.
Provided the tax charge exceeds £2,000, the tax liability can often be paid from the pension pot, provided the correct requirements are met.
Now, for the vast majority of people, they will never contribute £40,000 to their pension in any one year. They will also never contribute 100% of their net relevant UK earnings, as this would mean that they would be left with nothing to pay the cost of day-to-day living. When one considers that the average salary in the UK was until recently approximately £31,000 per year, you can see that the cap of £40,000 is pretty reasonable. Furthermore, the average Joe in the street is more than likely never going to be in a position to utilise the carry forward facility, so kindly made available by the government.
Despite this, the number of people having to pay the tax charge has increased year on year from just 5,460 in 2015/16 to 42,350 in 2019/20 (Written questions and answers - Written questions, answers and statements - UK Parliament)
So, why is there a spike in the number of people getting caught by the “annual allowance trap”? Is it because there has been a massive increase in the number of people diligently pouring money into their pensions? If only this were the case.
No, the true cause of this increase is the imposition of two restrictions on the annual allowance. These are:
- The Money Purchase Annual Allowance
- The Tapered annual allowance for high earners
The Money Purchase Annual Allowance (MPAA)
I believe that this little piece of legislation is actually the main cause of the spike in annual allowance charges, because it can impact anybody, rich or poor.
Basically, if you flexibly access taxable income from your pension using drawdown (either flexi-access drawdown or Uncrystallised Fund Pension Lump Sums), you will trigger the MPAA. This will automatically reduce your annual allowance down to £4,000 and you will no longer be able to use carry forward.
It is important to note that triggering the MPAA is very specific. It is not triggered if you simply draw tax free cash from your pension, purchase an annuity or start taking your final salary pension. It has to be triggered by using drawdown.
Furthermore, the MPAA may not be triggered if the taxable income is generated from the full surrender of a defined contribution pension that is smaller than £10,000, subject to the “small pots” rules.
The pension freedoms mean that people now have far greater liberty to access the capital within their pensions. Furthermore, people are now able to take their pensions while continuing to work and make further contributions to their pension pot.
This leads to a bit of a perfect storm where individuals, in need of a little extra cash to fund a holiday or help out the kids, access their pensions, taking tax free cash as well as a taxable lump sum. However, they do not realise that this will trigger the MPAA resulting in their personal annual allowance being reduced to £4,000 per annum. They continue working and funding their pension as before and inadvertently trigger a tax liability for themselves.
This is a really easy mistake to make, and I have come across many people who have accidently created this situation for themselves.
The tapered allowance for high earners
This is another piece of legislation that has caused many a high earner to drift into an unexpected annual allowance tax charge.
The rules are quite complicated, so I will summarise them very succinctly below:
Roughly speaking, the taper works by reducing the high earner’s annual allowance by £1 for every £2 that the high earners “adjusted income” (broadly taxable income plus pension contributions) exceeds the “adjusted income threshold” of £240,000. The annual allowance can be tapered down all the way to £4,000. Therefore, anyone earning an “adjusted income” of more than £312,000 will not be able to contribute more than £4,000 (plus any carried forward annual allowance) to a pension in a tax year.
Many people do not notice their pension contributions gradually creeping up as they move up the corporate ladder and before they know it, they have triggered an annual allowance charge.
Is it better to stop/reduce pension contributions when the annual allowance is being exceeded?
Triggering these tax charges generally cause the affected individual to immediately question whether it is better to stop making pension contributions altogether. Alternatively, it may seem beneficial to rather take advantage of any employer schemes that might allow the pension contributions to be paid as income.
There are a number of things to consider. Firstly, is your employer making contributions to the pension on your behalf, and will you lose these if you change your personal contributions? This is a crucial question, as the employer is basically giving you free money. At the end of the day, even if the contributions suffer a maximum tax charge of 45%, you are still getting 55% of money you wouldn’t have otherwise received. As the old saying goes, 55% of something is better than 100% of nothing. It is therefore worth finding out just how much your employer is contributing to your pension, and how much this will change if you reduce your contributions.
Sometimes, particularly in the finance world, employers make 10% - 15% non-contributory contributions into their employee’s pensions. This means that an employee can stop their own contributions completely and still receive 10% - 15% from their employer.
Some employers will offer the option for high earners to take their pension contributions as income instead. This may seem on the face of it to be attractive, but in reality, the pension contributions remain more attractive despite the annual allowance charge.
The reason for this is that the pension contributions are normally paid out of pre-tax cash. This means that the employee is not paying income tax or National Insurance on the pension contributions. However, if the pension contributions are taken as income instead, both the employer and employee would have to pay National Insurance contributions and the payment would be subject to income tax.
In addition to this, the pension contributions grow in a tax-free environment, and 25% of the pension contributions can be taken in the future as a tax-free lump sum.
When you add the fact that the pension value will generally not form part of the member’s estate for inheritance tax purposes should they die, the overall benefit of continuing to pay into a pension continues to ratchet up.
It is however worth noting that once the lifetime allowance is exceeded, then this calculation changes. The imposition of the lifetime allowance does start to make the continued contributions look rather unattractive and it is worth looking at taking the pension contributions as income, if possible.
As you can see, there are still strong arguments for continuing to pay into your pension, despite the imposition of annual allowance charges. In many cases, the annual allowance charge does reduce the tax efficiency available, but not sufficiently to stop the contributions.
It is worth noting that this does not hold true for everyone. Self-employed high earners may find that pension contributions are not as tax efficient as other options.
At the end of the day, it is worth taking financial advice in order to ensure that you haven’t accidently created an annual allowance tax liability and also to determine what the best course of action is.
If you would like further information, please don’t hesitate to ask us for our more complete guide on pensions and retirement available upon request through our website at www.atticusfp.co.uk. There you will also find guides on:
• Inheritance Tax and Estate Planning
• Investments and tax planning
• Pensions and divorce
You can also book a free initial consultation with us through our website, emailing us, or by phoning on 01420 446777.
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