As you might already be aware, the maximum amount an individual can contribute tax-free to their pension during a tax year is £40,000. However, this amount is restricted for high earners, who will have a tapered allowance which is dependent on their level of income.
The allowance has been restricted since the end of the 2015/16 tax year but as of 6th April 2020, there are new rules for the way in which the annual pension contribution allowance is calculated. This is great news for individuals with yearly income between £150,000 and £240,000 as they will now have the full £40,000 allowance.
An individual will have a tapered allowance if their Adjusted Income or Threshold Income are above certain limits. From 6th April 2020, the new threshold income limit has risen to £200,000 from £110,000 and the adjusted income limit has increased to £240,000 from £150,000.
‘Threshold income’ is generally net income less the gross amount of personal pension contributions.
‘Adjusted income’ is net income plus occupational pension contributions plus employer contributions.
‘Annual allowance’ is the maximum amount of pension savings that an individual can make during a tax year with the benefit of a tax relief.
Tapered annual allowance
The £40,000 Annual Allowance is reduced by £1 for every £2 that the adjusted income exceeds £240,000, to a minimum of £4,000.
Example: If your adjusted income for the 2020/21 tax year is £280,000, your income would exceed the adjusted income limit by £40,000 (£240,000 minus £280,000). Therefore, your annual allowance would be reduced by £20,000 and your new tapered allowance would be £20,000.
Once an individual’s adjusted income has reached £312,000 there is no further reduction, their tapered annual allowance would be limited to £4,000.
Example: If your adjusted income for the tax year 2020/21 is £320,000. Your income would exceed the adjusted income limit by £80,000. Consequently, your annual allowance should be reduced by £40,000. However, the minimum that the annual allowance can be reduced to is £4,000.
Excess pension contribution charge
If an individual exceeds the annual allowance in a tax year, they may be subject to an excess pension contribution charge. The excess pension contribution would be taxed at the highest marginal rate applicable, which would be 45% if the individual has a tapered allowance.
If an individual incurs an cess pension contribution charge, they can either pay the charge via their Self-Assessment Tax Return or by making a Voluntary Scheme Pays election.
‘Voluntary scheme pays’ is a process that allows an individual to pay the excess pension contribution charge directly from their pension. The individual would need to speak to their pension provider about doing this and it is only available under certain circumstances.
However, if an individual has been a member of a registered pension scheme during the previous three tax years, they might be able to carry forward unused annual allowances to cover the charge.
If you believe you may have made excess pension contributions, speak with your tax preparer to work out whether you have any unused allowances from earlier years.
More detailed guidance on this area can be found on https://www.gov.uk/government/publications/pensions-tapered-annual-allowance/pensions-tapered-annual-allowance