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Each tax year, a UK resident is usually entitled to put up to £40,000 into his/her pension(s) – or, up to 100% of earnings (whichever is lower). Putting money into a pension is one of the best ways to grow your nest egg due to tax relief. For a Basic Rate taxpayer, this is 20% and for a Higher Rate taxpayer it is 40%. Respectively, this means that it only “costs” the former 80p to put £1 into a pension whilst it only “costs” the latter 60p to do so.
However, tax penalties usually apply if you go over your “annual allowance” for contributing into your pension(s). Moreover, your annual allowance can be reduced (tapered down) if you start earning over a certain amount each year. Below, our team at Cedar House explains how the tapered annual allowance works and how to navigate the rules effectively.
We hope this is helpful to you. If you want to discuss your own financial plan with us, please contact our team for more information or to access personalised financial advice:
020 8366 4400 or enquiries@cedarhfs.co.uk
What is the tapered annual allowance?
As mentioned, pensions offer a generous tax advantage for those saving towards retirement. However, to try and level the playing field, the UK government has put rules in place to try and prevent higher earners from taking unfair advantage (e.g. putting millions of pounds from a recent business sale straight into a pension pot). One example of this is the lifetime allowance, which sets an overall “cap” on the tax-free amount you can save into a pension (i.e. £1,073,100 in 2022-23). Another is the tapered annual allowance.
The tapered annual allowance lowers the maximum amount someone can save into a pension each year without tax (i.e. £40,000). It starts to affect you if your ‘threshold income’ exceeds £200,000 and your ‘adjusted income’ is above £240,000. Those with earnings below these figures, naturally, should not need to worry too much. Those who sit near this bracket, however, may struggle to discern if – and how – they may be affected by the tapered annual allowance due to the complicated rules involved. Theoretically, if your earnings are high enough, then your annual allowance could be reduced to as low as £4,000 per tax year.
An example of the tapered annual allowance
To further illuminate how the taper works, let’s consider an example. Suppose Jonathan earns £220,000 per year from his salary and gets a £20,000 bonus. Moreover, he receives a further £10,000 from company shares that he owns – in the form of dividend payments. Finally, Jonathan puts £20,000 into his company pension each year, with his employer matching this with their own contributions.
In this case, Jonathan would be affected by the tapered annual allowance. This is because his threshold income (£220,000) is above the £200,000 threshold and his adjusted income (which is £270,000) is over the £240,000 threshold. In this case, his annual allowance of £40,000 would be reduced by £30,000 – i.e. the difference between his adjusted income and the £240,000 threshold. Therefore, his annual allowance for 2022-23 would be £10,000.
Ideas to navigate the tapered annual allowance
Before higher earners charge forward with trying to “get around” the annual allowance taper, make sure you first check that you will not eventually end up exceeding the lifetime allowance on pension savings. Remember, this is £1,073,100 in 2022-23 and it is often easier to go over this than you may think. The penalties can be heavy. Anything withdrawn as income above this threshold will be taxed at 25%; a lump sum would be charged at 55%. A financial adviser can help you run the necessary calculations to make sure you are on the right track.
Assuming you are not at high risk of exceeding the lifetime allowance, there are some options that you can explore with a professional to try and navigate the tapered annual allowance. One idea is to check whether you have any used allowance from previous tax years that you can “carry forward” to the present one. Here, just be aware that income definitions used to be lower. On 6 April 2016 and 5 April 2020, ‘threshold income’ was above £110,000 and ‘adjusted income’ was above £150,000. You will need to look at the annual allowance available in each tax year – as well as how much you put into your pension(s) – to find out if anything can be carried forward.
Another option is to explore other tax-efficient investment vehicles which can help you save for retirement – such as a stocks & shares ISA. You can put up to £20,000 into your ISA(s) each tax year and generate interest, capital gains and dividends without these getting taxed. If you have gone over your yearly tax-free allowances for capital gains (£12,300) and dividends (£2,000) then this can help shield your returns from the taxman. Saving tax-efficiently outside of your pension also opens up more flexibility since there is no total “cap” on your ISA savings, and you are not limited by age when it comes to making withdrawals.
Conclusion
Interested in discussing your financial plan with an experienced financial adviser? Get in touch today to discuss your financial plan with a member of our team here at Cedar House via a free, no-commitment consultation:
020 8366 4400 or enquiries@cedarhfs.co.uk