In the second article in our short series on tax year end planning, Stephen McPhillips, Technical Sales Director, Dentons Pension Management Limited, looks at the traps awaiting clients in respect of the pensions annual allowance.
The annual allowance (AA) was introduced on 6 April 2006 (so called “pensions A-day”). It was part and parcel of “pensions simplification” and the AA brought about uniformity of maximum tax-relievable pension contributions to defined contribution schemes. Prior to then, maximum contributions to occupational schemes had to be calculated in a different way from those to retirement annuity contracts and personal pension schemes. However, matters relating to maximum tax-relievable contributions are not as simple as they might have been immediately after A-day and it is particularly important to bear this in mind in the lead up to any tax year end.
Tax trap 1 – the AA and tax relief
The first key aspect to remember is that the AA is separate and distinct from tax relief itself, even though they need to be considered in conjunction with each other. It might be easy to assess that a client’s available AA is £40,000 in the current tax year (the AA is currently £40,000, and it has been for a number of years now), but that does not automatically mean that the client can have a tax-relievable contribution of £40,000 paid into a pension scheme.
Let’s assume that this is a Member contribution. In order to be granted full tax relief, the client must have pensionable earnings in the current tax year of at least £40,000. This is because tax-relievable Member contributions are limited to the greater of £3,600 and 100% of the member’s pensionable earnings. If the client’s earnings sit below £40,000 in the current tax year, a Member contribution of £40,000 will not enjoy tax relief in full.
Although Employer contributions are not constrained by pensionable earnings in this way, they are still subject to the AA and the AA applies to combined Member and Employer contributions.
Tax trap 2 – tapering of AA
Tapering of AA was brought into existence on 6 April 2016 and, where it bites, it reduces the scheme member’s AA on a sliding scale where his or her “adjusted income” and “threshold income” exceed the relevant limits. These income figures are defined, and they capture a lot of forms of income, so careful attention has to be paid to the member’s overall source of wealth in a given tax year. For example, “adjusted income” includes the member’s earnings, dividends, interest on savings and pension contributions (including those made as a result of a salary sacrifice (or similar) arrangement).
With effect from 6 April 2020, “adjusted income” and “threshold income” amounts were increased by £90,000 each, thereby taking large numbers of pension scheme members out of the scope of tapering (most notably some senior clinicians in the public sector). Hence for the tax year 2020/21, “threshold income” was set at £200,000 and “adjusted income” was set at £240,000 and that is the case for the current tax year (2021/22). Where the client’s adjusted income is £312,000 or more, the AA reduces to a floor amount of £4,000.
Adviser firms may wish to keep an ongoing record of any tapered AA each year, regardless of whether contributions are intended.
Tax trap 3 – carry forward of unused AA
It is important to bear in mind that unused AA from the current tax year, and from the previous 3 complete tax years, has to be calculated in line with the requirements above. For example, it is necessary to establish whether the client has been subject to tapering in the current and previous tax years.
It is also crucial to establish whether the client has been subject to the Money Purchase Annual Allowance (MPAA) (also currently £4,000).
For clients subject to the MPAA (for example, as a result of drawing retirement income or taking uncrystallised funds pension lump sum (UFPLS)), there is no carry forward available at all for money purchase pension schemes, even if in the three previous years they were not subject to the MPAA.
