PENSION TAPERED ANNUAL ALLOWANCE FOR HIGH EARNERS

The pension tapered annual allowance is a serious issue if you earn a high income. It could lead to significant extra tax bills.

If your total income is greater than £240,000, and you pay into a pension plan, you need to be aware of the pension tapered annual allowance for high earners. You may find that your ability to make pension contributions is reduced by up to £36,000, and this could mean you must pay additional tax at up to 45%.

This article was updated on 9th April 2021, and reflects the tax rates which apply in the 2021/22 tax year.

Key points

  • If your ‘adjusted income’ of taxable income plus pension contributions is greater than £240,000, your pension annual allowance reduces gradually to a minimum of £4,000
  • This tapered annual allowance for high earners reduces your annual allowance by £1 for every £2 of income between £240,000 and £312,000 to a maximum annual allowance loss of £36,000
  • Payments to pensions which exceed the tapered annual allowance are taxed at 45%
  • You cannot use salary exchange to reduce your income below £240,000
  • You can still use carry forward for unused pension annual allowance for up to 3 tax years
  • Examples of the tapered annual allowance for high earners in practice

The pension tapered annual allowance for high earners

Currently, everyone has an annual allowance, which permits you to pay up to £40,000 into your pension schemes. This applies to contributions from all sources, per tax year.

Any payments over this figure are subject to an additional tax charge at your marginal rate of income tax – 20%, 40% or 45%, depending on your earnings.

The annual allowance has reduced dramatically in recent years, from £255,000 in 2011/12 to its current level of £40,000. If you are taking taxable income using flexible drawdown then your annual allowance is reduced to £4,000 (known as the Money Purchase Annual Allowance).

Carry forward

If you have not used your full pension annual allowance in the past 3 years, and were a member of a pension scheme during that period, then you may be allowed to carry forward unused annual allowance for these 3 years. Therefore, it may be possible to pay pension contributions in excess of the standard annual allowance in certain circumstances without incurring tax. The tax relief provided on your pension contributions is paid at source, and you must account for any excess contributions over the annual allowance in your tax return. It is important to remember that the carry forward calculations will be affected by the changes to the tapered annual allowance between 2019/20 and 2020/21. This can make the calculations quite complex.

The tapered annual allowance for high earners

If your ‘adjusted income’ is over £240,000 you may find that your ability to make pension contributions has been reduced. It is quite possible that your current pension contributions would incur additional tax at 45%.

Adjusted income over £240,000 will reduce your pension annual allowance by £1 for every £2 above this figure. The annual allowance for pensions will reduce to a minimum of £4,000 per tax year if you earn more than £312,000.

Prior to 6th April 2020, the tapered annual allowance started at a lower level (£150,000), and reduced gradually to £10,000 for income over £210,000. Now, the tapered annual allowance starts at a higher threshold, but could reduce to a lower annual allowance if you earn over £300,000.

How the tapered annual allowance makes pension planning difficult

Each tax year will be treated differently, so your earnings in one year might reduce your annual allowance, but in other years you might have the full annual allowance. This can make it difficult to plan for high earners. Many high earners receive unpredictable income, such as bonuses or share awards. This usually comes at the end of the tax year. Ultimately, this may mean that you are subject to the tapered annual allowance in one tax year, but not another. You may not know the full picture until you are awarded your final bonus. This will make it difficult for you to plan your pension contributions using bonus sacrifice, which is a tax-efficient method of giving up some of your bonus in exchange for tax relief into your pension.

How the tapered annual allowance changed from 2020/21

Tapered annual allowance for higher earners 2020

This chart shows the effect of the changes between the 2019/20 and 2020/21 tax years. The blue line shows the tapered annual allowance and how operated in the 2019/20 tax year, depending on your adjusted income. The green shaded area shows the new adjusted income bands from 6th April 2020. You can clearly see the improved tapered annual allowance for adjusted incomes between £150,000 and £240,000. Unfortunately, the tapered annual allowance reduces from £10,000 to £4,000 for those earning between £300,000 and £312,000.

What is adjusted income?

If your adjusted income is greater than £240,000 you will start to lose your annual allowance. This was £150,000 prior to 6th April 2020.

Adjusted income includes the total of the following:

  • Employment income – salary, bonus, benefits in kind
  • Profits from self-employment
  • Pension income
  • Property income
  • Dividends
  • Savings income
  • Taxable lump sum death benefits
  • Employer pension contributions
  • Salary exchange contributions
  • Individual pension contributions under a ‘net pay’ scheme – usually from an occupational pension scheme or retirement annuity contract

If you pay into a personal pension, then your individual pension contributions usually come out of net pay, and therefore do not need to be added back to adjusted income.

Employer pension contributions do count in adjusted income.

Any pension contributions which may be made to reduce your taxable income, such as salary exchange, are now taken into account when determining your adjusted income for your pension annual allowance if you are a high earner.

You can use some allowances to reduce adjusted income, such as gifts to charities.

An exception – threshold income below £200,000

If your ‘threshold income’ is not greater than £200,000 in a tax year, the annual allowance is not tapered for that tax year. These rules are designed to protect lower earners. The Threshold Income limit was set at £110,000 prior to 6th April 2020.

What is threshold income?

If your threshold income is less than £200,000 (£110,000 prior to 6th April 2020) then you cannot be subject to the tapered annual allowance, even if your adjusted income is greater than £240,000 (£150,000 prior to 6th April 2020).

Threshold income includes:

  • Income from employment- salary, bonus, benefits in kind
  • Profits from self-employment
  • Pension income
  • Property income
  • Dividends
  • Savings income
  • Taxable lump sum death benefits
  • Salary exchange contributions to pensions since 9th July 2015
  • Individual pension contributions under a ‘net pay’ scheme – usually from an occupational pension scheme or retirement annuity contract

Importantly, this definition does not include employer pension contributions. If a salary exchange arrangement was set up before 9th July 2015 this amount is not included in your threshold income. Therefore, business owners can legitimately pay employer pension contributions to reduce their threshold income, subject to anti-avoidance measures (see below).

Example 1 – Adjusted income over £240,000

Julie receives the following income and pension benefits.

  • Salary of £230,000.
  • Employer personal pension contributions of 10% of salary per year, or £23,000.
  • Bonus £37,000
  • Total remuneration – £290,000

Julie’s adjusted income is £290,000. Since this takes Julie over the £240,000 threshold, the additional £50,000 means a £25,000 reduction in the pension annual allowance to £15,000. Since Julie’s pension scheme benefits from tax relief at source, her personal contributions are not added back in to the adjusted income calculation.

Julie’s tapered annual allowance is now £15,000. Her employer pension contributions exceed this annual allowance by £8,000. Therefore, Julie will need to pay additional tax of 45% on the excess, via her tax return. This would mean additional income tax of £3,600.

What if Julie does not receive a bonus?

Imagine the same figures in the following tax year, without the bonus.

Julie’s total remuneration (without the bonus) is now £253,000. The excess of £13,000 over £240,000 reduces Julie’s annual allowance by £6,500. Her tapered annual allowance is now £33,500. Julie’s employer pension contributions (£23,000) are within the tapered annual allowance, meaning no additional income tax charges. In fact, Julie could pay in an additional £10,500 in personal contributions to her pension scheme without incurring additional tax charges, or having to use carry forward.

Example 2 – Threshold income below £200,000

Tim runs a business and pays himself a salary of £12,000, plus dividends of £88,000. He also owns 6 rental properties, providing a total income of £50,000. His taxable income is therefore £150,000, which is below the threshold income figure of £200,000. If he pays a company contribution of £120,000, this will not reduce his annual allowance, since his threshold income is below £200,000. The fact that his adjusted income is now £270,000 is not relevant.

Anti-avoidance measures

The legislation includes anti-avoidance measures to stop you trying to avoid the impact of the tapered annual allowance.

Therefore, you could be caught within these measures if:

  • You use salary sacrifice to give up the right to income in return for the making of a relevant pension contribution; or
  • You manipulate your remuneration so that your employer agrees that pension contributions are made instead of other employee benefits.

Any arrangement will be caught by the anti-avoidance measures if:

  • it is reasonable to assume that the main purpose, or one of the main purposes, is to reduce the impact of the tapered annual allowance; and
  • the arrangement has the impact of reducing either or both the adjusted income or threshold income figure; and
  • the reduction in either or both adjusted income or threshold income is redressed by an increase in the individual’s adjusted income or threshold income for a different tax year.

Where an arrangement is caught by the anti-avoidance measures it will be ignored for the purpose of calculating the tapered annual allowance.

What can you do to avoid the tapered annual allowance for high earners?

If your income exceeds the £200,000 threshold income level then there is little you can do to avoid the tapered annual allowance. If you own a business you may be able to adjust your income levels to bring your total income below the threshold income level, but you should take care not to fall foul of the anti-avoidance measures. Because pension contributions are not included in the definition of threshold income you may be able to use a pension contribution to take profits from the business if your threshold income is below £200,000.

In practice, employees will find it very difficult to avoid the additional tax payable on pension contributions. This will be especially true if you receive bonuses at the end of the tax year. Pension contributions already made throughout the tax year may now attract additional tax purely because of a large bonus which reduces your annual allowance.

The only alternative will be to use carry forward wherever possible.

Without available pension annual allowance, many high earners choose to forego pension contributions, and instead take salary in lieu of their pension. The basic reasoning is that if you are going to be charged additional income tax, you might as well receive the salary, rather than pay into the pension. However, there are occasions where it may continue to be worthwhile to receive pension contributions from your employer, even if these attract additional tax charges. It makes sense to do the tapered annual allowance calculations for each tax year.

What to do if you are a high earner

The best solution is to contact us to examine the figure so that you fully understand your tax position. Our Prosper service is designed for High Income clients. We will assess your pension allowance position for each tax year, and recommend the best way to reduce tax. We can also help you to minimise tax where possible using your other tax allowances.

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