The annual allowance is a limit on the amount that can be saved into a pension each year with valuable tax breaks. The allowance itself is quite generous (up to £40,000 per annum), but of possibly more significance is the ability to carry forward unused annual allowance from the previous three tax years.
While there are a number of restrictions and conditions applicable to the annual allowance, in certain circumstances, an individual can contribute up to £160,000 to their pension in a single tax year in a very tax efficient manner.
Attraction of making pension contributions
In the case of an employee making personal contributions to pension, the attractions of doing so in the current 2020/21 tax year include:
- Income Tax relief at the individual’s highest marginal rate;
- Investment towards a fund that is able to grow virtually tax-free;
- The ability to take up to 25% of the fund as a tax-free Pension Commencement Lump Sum (PCLS) at any point from age 55;
- Access to income in retirement beyond this PCLS potentially at a lower rate of Income Tax than the rates of relief granted on the way in;
- The ability to access benefits flexibly to optimise tax efficiency; and
- Building up a fund that in most circumstances should not form part of the individual’s taxable estate.
While personal contributions to pension immediately benefit from basic rate Income Tax relief (ensuring that £20 tax relief is added to every £80 contributed), higher and/or additional rate income tax relief will be granted via the individual’s tax return. Where taxable income exceeds £100,000 however, you start to lose your Personal Allowance (£1 lost for every £2 of income above £100,000). Once earnings reach £125,000 therefore, the entire personal allowance is lost.
However, as contributions to pension effectively reduce the level of an individual’s taxable income, if someone earnings £125,000 contributes £20,000 net of basic rate tax relief (£25,000 gross) to their pension, not only will they benefit from higher rate tax relief, they will also fully restore their personal allowance. The effective rate of tax relief on this contribution is therefore 60%, which means that once fully tax relieved, the £25,000 contribution only costs the individual £10,000. This means that a contribution that only cost the member £10,000 benefits from immediate risk-free growth of 150%.
As noted earlier however, there are a number of restrictions and considerations that must be taken into account. In the first instance, while the Annual Allowance is £40,000 (and unused Annual Allowance can be carried forward), the level of tax-relievable contributions that can be made will be limited by net relevant earnings and affordability.
Investors should also bear in mind that they will have no access to their pension funds until they reach age 55 at the earliest and when they do, they will be limited to drawing up to 25% of the accumulated fund as a tax-free Pension Commencement Lump Sum – the balance 75% must be used to provide a taxable retirement income. If benefits are not drawn on a sustainable basis, the pension funds will not last throughout your retirement.
Tapered annual allowance
The standard £40,000 annual allowance is reduced by £1 for every £2 of adjusted income an individual has over £240,000 (in the 2020/21 tax year, increased from £150,000 in 2019/20). Tapering continues until the annual allowance reduces to £4,000 once adjusted income reaches £312,000.
While high earners’ ability to make meaningful contributions to pension will obviously be severely restricted where earnings exceed £312,000, where earnings were lower than this in any of the previous three tax years, they may still be able to make use of carry forward of more useful levels of contribution from earlier annual allowances.
Money purchase annual allowance
The annual allowance may also be reduced when pensions are flexibly accessed via pension freedoms. The money purchase annual allowance reduces the annual allowance from £40,000 to £4,000 – but only for contributions to money purchase (Defined Contribution) schemes – such as personal pensions.
Members of money purchase pensions should therefore be aware that their ability to make meaningful contributions to pension will be significantly reduced should they access:
- An uncrystallised funds pension lump sum (UFPLS);
- Flexi-access drawdown (for the first time, or converted from capped drawdown);
- A flexible annuity;
- Income greater than the limit of capped drawdown.
There are however certain benefits that can be drawn without triggering the money purchase annual allowance, such as drawing:
- Pension Commencement Lump Sum only;
- Secure income – such as a non-flexible annuity or defined benefit pension;
- Capped drawdown;
- Small pots – taken as lump sums under the triviality or stranded pots rules;
- Survivors’ pensions.
Higher rate tax relief
As noted, Income Tax relief and particularly higher rate tax relief is a significant attraction of making contributions to a pension.
Where individuals have the scope and ability to make use of their annual allowance and perhaps the carry forward of unused pension contributions from previous tax years, especially where these contributions will attract mainly higher rate tax relief, I would urge them to consider doing so – sooner rather than later.
I believe that the enormous costs associated with supporting the country through the continuing Covid-19 pandemic will eventually result in the abolition of valuable tax breaks for higher earners – such as higher rate tax relief on pension contributions.
While Mr Sunak may not introduce a raft of tax reforms when he delivers his Budget statement on the 3rd of March, at some point I think soft targets such as pension contribution tax relief will be picked off.
At the present time, not only can individuals make use of their own annual allowance availability, contributions to spouse’s, children’s and even grandchildren’s pensions can be utilised. Early discussions with your trusted financial planner should therefore be sought.
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.
Investment does involve risk. The value of investments and the income from them can go down as well as up. The investor may not receive back, in total, the original amount invested. Past performance is not a guide to future performance. Rates of tax are those prevailing at the time and are subject to change without notice. Clients should always seek appropriate advice from their financial adviser before committing funds for investment. When investments are made in overseas securities, movements in exchange rates may have an effect on the value of that investment. The effect may be favourable or unfavourable.
Source: HMRC 2020/21.
Smith & Williamson Personal Financial Planning. A division of Smith & Williamson Financial Services Limited which is authorised and regulated by the Financial Conduct Authority. Tilney Smith & Williamson Limited 2021.
This article was previously published on Smith & Williamson prior to the launch of Evelyn Partners.