A few weeks ago I wrote about the Lifetime Allowance (LTA). The LTA was brought in on A-day (6 April 2006) when there was an overhaul of UK pensions. (It’s worth having a read of that piece for some of the background history).
At the same time, the Annual Allowance (AA) was also introduced. The AA is very much the Ashley to the LTA’s Mary-Kate (or if you prefer, the Ronnie to the Reggie).
So in this post, I’m going to look into the Annual Allowance and ‘square the circle’.
What the Annual Allowance is and why it exists
The Annual Allowance for 2018/19 is £40,000. What happens is this: if your total contributions into your pensions are greater than £40,000 you will have to pay a tax charge. This tax charge is the top marginal income tax rate on the excess above the AA.
As I mentioned in my Lifetime Allowance post, when you put money into a pension the Government provides tax-relief. The underlying principle under the pension tax-relief system is that you defer taxes.
With the Annual Allowance, the Government is basically capping the amount of tax relief they will give you in a year. In effect, the Government is saying: “you’ve got enough from us, you’re on your own now”.
This seems quite reasonable in principle – should the Government be subsidising the pension savings of the very rich? In general, I agree with this principle. But there are some issues.
Firstly, people don’t earn a consistent salary over their career. They are likely to earn much more in later years – and therefore, contribute much more to their pensions.
Secondly, as we saw with the Lifetime Allowance, lots of Government tinkering has (in my view) resulted in some unintended consequences which feel like they defy the spirit of what is trying to be achieved (more on that later).
Before we jump in, it’s very important to note that the Annual Allowance operates separately and differently to tax relief rules. Let’s quickly touch on the tax relief rules.
Currently, tax-relief on gross individual pension contributions is limited to £3,600 or 100% of relevant UK earnings per tax year. Importantly, there is no carry forward of unused tax-relief.
The Annual Allowance works differently. It’s based on ‘Pension Input Amounts’ – the total of all pension contributions. These are tested over ‘Pension Input Periods’ which (historically) are not necessarily the same as tax years. The AA can also be carried forward. The AA also varies depending on how much you earn and whether or not you have taken some pension benefits.
History of the Annual Allowance
The Annual Allowance came into existence on 6 April 2006, known to those in the pensions industry as A Day. A Day is the Pension expert’s equivalent to the birth of Christ – things are either pre-A Day or post-A Day.
Prior to A Day there were a number of rules and limits to how much could be contributed to an individual’s pension.
The starting Annual Allowance was £215,000, increasing up to £255,000 in 2010/11. It was then dramatically slashed down to £50,000 in 2011/12 before being cut further to £40,000 in 2014/15.
Source: Royal London
You’ll notice some asterisks by some of the figures.
Due to the dramatic change in the Annual Allowance in 2011/12, a one-off pension ‘straddling’ adjustment was available. I won’t delve into the detail, but if 2011/12 is relevant for your AA, remember that there are some special rules that applied (your financial planner or accountant will help with the calculations).
In 2015/16 the Government aligned pension input periods to tax years. Before then, pension input periods and tax years were not necessarily aligned. The Government adjusted the Annual Allowances so that for the period 6 April 2015 to 8 July 2015 the AA was £80,000, for the period 8 July 2015 to 5 April 2016 the AA was zero. But you could carry forward the lower of £40,000 and £80,000 less what you input between pre 8 July; minus what you input post 8 July. In effect, you could get up to £80,000 in AA.
With the introduction of pension freedoms in 2015, the Money Purchase Annual Allowance (MPAA) was introduced to further limit the amount of tax-relief available for those who have accessed some of their pensions. In 2015/16 and 2016/17 the MPAA was £10,000 before being reduced to £4,000 in 2017/18.
Finally, In 2016/17 the Government introduced the Tapered Annual Allowance (TAA), potentially reducing an individual’s allowance to a minimum of £10,000 (more on that later).
How it works
The Annual Allowance is assessed each tax year.
The first step is to calculate the total pension contributions in the relevant Pension Input Period.
For defined contribution pensions this is calculated as:
For defined benefit, it’s a little bit more complicated:
Here’s an example DB input calculation from the HMRC tax manual:
Tina is a member of a final salary scheme giving her a pension of 1/60th pensionable pay for each year of service. At the start of the pension input period Tina’s pensionable pay is £80,000 and she has 31 years pensionable service. At the end of the pension input period Tina’s pensionable pay has risen by 5 per cent to £84,000 with 32 years pensionable service.
Tina does not have any other pension arrangement.
Step 1: Calculate opening value
Annual Pension: 31/60 x £80,000 = £41,333.33
Multiply by factor of 16: £41,333.33 x 16 = £661,333.28
Increase by CPI (say 3%): £661,333.28 x 1.03 = £681,173.27
Step 2: Calculate closing value
Annual pension: 32/60 x £84,000 = £44,800
Multiply by factor of 16: £44,800 x 16 = £716,800
Step 3: calculate pension input amount
Closing value – opening value = £716,800 – £681,173.27 = £35,626.73.
Therefore, Tina is within the Annual Allowance and there is no charge.
Carry forward is available which allows unused Annual Allowance from pension input periods ending in the previous three tax years to be carried forward. It is then added to the annual allowance for the current pension input period.
It’s important to bear in mind the transitional changes in 2011/12 and 2015/16 (you can read more about the specific steps to take here at Pru Adviser: https://www.pruadviser.co.uk/knowledge-literature/knowledge-library/annual-allowance-carry-forward/#section-3)
You can find a number of worked examples of carry forward in the HMRC tax manual (link).
Also note that you don’t need to make a claim to HMRC to use carry forward.
The charge is levied on the excess of pension contributions above the Annual Allowance. So if there an individual has contributed £50,000, the excess if £10,000 (£50,000 – £40,000).
This excess is charged at the individual’s marginal rate. In effect, it sits on top of an individual’s taxable income.
Bear in mind, you must self-assess. If you’ve exceeded the Annual Allowance you’ll need to record this in your tax return.
It’s possible to get your pension scheme to pay the charge for you, under the ‘Scheme Pays’ system. This is available if:
- The total annual allowance charge is over £2,000, and
- The inputs are in excess of the standard annual allowance in the scheme.
Pension schemes must provide the information you need for calculating your pension inputs automatically each year. But don’t rely on your various schemes, it’s up to you. If necessary, get in contact to get the information you need.
Tapered Annual Allowance
In 2016/17 the Government introduced the Tapered Annual Allowance (TAA). Aimed at ‘high earners’, the Annual Allowance is reduced for people who have ‘adjusted income’ over £150,000 and ‘threshold income’ over £110,000 a year. The AA reduces by £1 for every £2 over £150,000 down to a minimum of £10,000.
As noted above, both adjusted income and threshold income need to be above the limits. If you are over only one of the limits, the taper doesn’t apply.
Calculating adjusted and threshold income
Both include all taxable income. The difference between the two can be summarised as: adjusted income includes all pension contributions (including employer and salary sacrifice), threshold excludes pension contributions.
Unfortunately, there have been a number of unintended consequences with the Tapered Annual Allowance.
Firstly, it’s thought that thousands of people were unintentionally snared by the change and hit with unexpected tax-bills (Professional Adviser).
Secondly, lots of individuals accruing DB pensions above the Annual Allowance have now found that they aren’t eligible for Scheme Pays (FT Adviser). Leaving some with big cash holes to fill.
Finally, I’m aware of several employers who have capped their pension contributions for high earning employers at £10,000 to avoid leaving their employees worse-off from a cash perspective. The difficulty (impossibility?) in employers knowing what other sources of income their employees have means that many have opted to just avoid the whole problem and reduce pension contributions and to pay other types of benefits in lieu. (see FT)
Money Purchase Annual Allowance
In 2015 the Government brought in the fabled Pension Freedoms. This necessitated the need to introduce a new allowance to prevent individuals crystalising a pension and ploughing the money back into a pension.
Thus the Money Purchase Annual Allowance (MPAA) was born. From 6 April 2015, an individual taking income from Flexi-Access Drawdown (FAD) or taking an Uncrystallised Funds Pension Lump sum (UFPLS) triggers the MPAA. Initially, the MPAA was at £10,000 before being dramatically slashed to £4,000 on 6 April 2017.
The MPAA triggers if an individual:
- Takes a PCLS and income (FAD)
- Takes an UFPLS
- Exceeds the GAD rate in a capped drawdown (i.e. turns a capped drawdown into a FAD).
- Takes a Flexible Annuity (depending on specifics)
It does not trigger when an individual only:
- Takes a PCLS only
- Remains in capped drawdown
- Takes an annuity (non-flexible)
- Takes a small pot (via commutation)
The Money Purchase Annual Allowance applies to DC only, but not to DB accrual. However, DB contributions are still tested against Annual Allowance. There is no carry forward of the MPAA. Note, the MPAA doesn’t replace the current AA, if applicable, the MPAA and AA will be calculated alongside each other.
Annual Allowance Planning
As I highlighted in the LTA post, paying a tax charge isn’t necessarily a bad thing. As Pru Adviser note:
Opting out to save a tax charge, even if the net benefit is better, would be a bit like a client asking their employer to stop paying their salary because there is a tax charge.
Here are some helpful steps to think about when thinking about the Annual Allowance:
- What benefits will you get if you keep contributing – thinking about levels of contribution, future salary increases, interaction with Tapered Allowance
- What will it cost (net of tax relief) to get those benefits
- Calculate the overall benefit receivable net of tax charges. In addition, will the scheme pay, if you’re in a DB scheme what is the commutation factor?
- What will the benefit be if you stopped contributing today?
- In addition to (4), what is the value of alternatives benefits (employer paying different benefits)
- What will you do instead of contributing to the pension? Will you receive more salary? Invest in ISAs or other investment vehicles? Are there differences in access and risk factors compared to the pension?
Below is an example:
Say we have two individuals, both 45% taxpayers each with a salary of £210,000 (so they have a TPAA of £10,000) with no carry forward available.
One is a member of a DB 1/60th scheme, employee contribution is 6% with scheme pays at commutation factor of 20:1.
The other is a member of a DC scheme where the employer pays 6% of salary, and employee contributions are matched 1:1 up to 6%. The scheme pays the AA charge.
Having done the number crunching it leaves us with a few questions. For the DB member, is it worth paying £6,930 today for an extra £2,465 each year after retirement? For the same cost, the DC member gets an additional pension amount of £25,290. Is it worth the cost? Or are there alternatives which are better value? The judgment will, of course, depend on the circumstances for each individual and their financial goals and plan.
Closing – key points
- The AA regime is a cap on the amount of tax relief the Government will give you in a year
- It’s assessed each year on total pension contributions (yours plus employer plus third parties). The calculation varies between DC and DB.
- It’s possible to carry forward unused annual allowance from the previous three tax years.
- If both your ‘adjusted income’ is over £150,000 and ‘threshold income’ is over £110,000 your AA is tapered by £1 for £2 down to a minimum of £10,000.
- If you flexibly access your pensions you will be hit by the MPAA at £4,000.
- Paying an AA tax charge is only bad if the net benefit isn’t “worth it”
Please let me know your thoughts. Have you done any Annual Allowance Planning? Has the dramatic fall in the Annual Allowance changed what you (or your employer) have done with your pensions? Do you think the Money Purchase Annual Allowance will affect you?
Disclaimer: Please note, I’m not an FCA authorised financial adviser. This site provides information, comment and opinion for information purposes only and should not be considered financial advice. The site may contain incorrect information or mistakes. You should do your own research or speak to an authorised financial advisor or financial planner before making any and every investment decision. If you make an investment or decision on the basis of any information you do it at your own risk.
All the best,
Young FI Guy