The Tapered Annual Allowance

As we approach the end of the tax year, many people are considering making a further pension contribution and I am often asked about the Tapered Annual Allowance that affects high earners.

Key Points

There are a few points to be aware of:

The Tapered Annual Allowance does not apply to people who have ‘Threshold Income’ of less than £200,000.
The Annual Allowance is reduced for those people who have ‘Adjusted Income’ of over £240,000 per year.
The Annual Allowance reduces by £1 for every £2 over £240,000.
The maximum reduction is £36,000 which will apply when ‘Adjusted Income’ is over £312,000.

Definitions

The key to working out whether you are affected by the Tapered Annual Allowance is by applying the definitions of ‘Threshold Income’ and ‘Adjusted Income’ which can be a bit tricky!

Calculating Threshold Income

The first thing to do is add up the following:

Your salary (do not include any contributions made through salary sacrifice).
Any bonuses, commissions and benefits-in-kind.
Income from property.
Dividend payments and interest from savings.
Any self-employed earnings.
Any salary/ bonus you have sacrificed for pension contributions if:

1. The arrangement started on or after 9th July 2015.

2. Your contributions have increased since 9th July 2015.

You now need to deduct:

Any contributions you made to a pension (do not include any contributions made by your employer).
Certain reliefs you may be entitled to, for example, those applying to charitable donations.

This will give you your ‘Threshold Income’. If it is £200,000 or less you will not be affected by the Tapered Annual Allowance and the calculation ends.

If your ‘Threshold Income’ is above £200,000 you will only be affected by the Tapered Annual Allowance if your ‘Adjusted Income’ is over £240,000. You now need to calculate your ‘Adjusted Income’.

Calculating ‘Adjusted Income’.

The first thing to do is add up the following:

All your taxable income (as per the ‘Threshold Income’ calculation above).
Any contributions your employer has made to your pension (including any made by salary sacrifice).
Benefits built up in a Defined Benefit Scheme excluding the cost of your contributions.
Any contributions make to a Workplace Pension where the contributions were taken from your gross pay before tax (known as the net pay arrangement).

You should then deduct:

Certain reliefs you may be entitled to, for example, those applying to charitable donations.

You should now have your ‘Adjusted Income’.

If it is less than £240,000, the Tapered Annual Allowance does not apply.

If your ‘Adjusted Income’ is more than £240,000 (and your ‘Threshold Income’ is above £200,000) your Annual Allowance will be reduced by £1 for every £2 of adjusted income over £240,000 until it reaches the minimum of £4,000.

What happens if I exceed the Annual Allowance

If you exceed the Annual Allowance, the first thing to do is to check whether you can ‘carry forward’ any unused Annual Allowance from the previous three tax years. This may reduce or even eliminate any excess.

If there is still an excess amount, you will face an Annual Allowance charge. The excess amount is usually added to your income and subject to Income Tax at your highest marginal rate. This is then paid via your Self-Assessment. In some cases, the tax can be paid via the pension (with a deduction in your benefits) and this is known as ‘Scheme Pays’. Certain conditions need to be met before this can happen.

Meet Mike

By way of an example, let’s look at Mike’s situation.

Mike earns £220,000 and receives a bonus of £10,000. He also receives £2,000 in interest from his savings and £7,500 in dividends from his investments. Mike pays £14,000 into his pension and his employer matches it.

Mike’s ‘Threshold Income’

Salary = £220,000 plus
Bonus = £10,000 plus
Interest = £2,000 plus
Dividends = £7,500 less
Mike’s Pension Contribution = £14,000
Total ‘Threshold Income’ = £225,500

As Mike’s ‘Threshold Income’ is above £200,000, we have to move to the next calculation.

Mike’s ‘Adjusted Income’

Salary = £220,000 plus
Bonus = £10,000 plus
Interest = £2,000 plus
Dividends = £7,500 plus
Employer’s pension contribution = £14,000
Total ‘Adjusted Income’ = £253,500

Mike is subject to the Tapered Annual Allowance and his Annual Allowance will be reduced by £13,500 / 2 = £6,750 and will therefore be £33,250.

As Mike’s total pension contribution is £28,000 he has no Annual Allowance Charge to pay.

Conclusion

Pension contributions remain one of the most tax efficient ways to save for your retirement although, for high earners, working out how much you can pay can be quite complex.

It is always worth checking to see if you can carry forward any unused Annual Allowance from previous tax years.

If you would like any help with your pensions, please do get in touch.