Caught by the tapered annual allowance? 3 things you need to do
For years, high earners in the corporate world have been able to stick their heads in the sand, knowing their large pension benefits will ‘sort them out’ later down the line. With the tapered annual allowance, that’s now coming to an end.
The relatively recent introduction of the Tapered Annual Allowance rules has resulted in several high earning employees ‘opting-out’ of their pensions for fear of hefty tax bills.
What is the tapered annual allowance?
Since April 2016, employees in the UK earning between £150,000 and £210,000 per year have been subject to a new pension tax rule called the Tapered Annual Allowance (TPAA). The TPAA gradually reduces how much you can put into your pension (whilst gaining tax relief), starting at £40,000 and ‘tapering’ down to just £10,000.
So employees earning over £150k have a gradually reducing allowance and once earners hit £210k or above, they, or their employers, can only put in £10k per year (or face a tax charge).
Earnings over £110k?
You might be thinking “hang on, didn’t you just say ‘earners over £150,000’?”, and you’d be right, I did. However, that doesn’t tell the full story…
Even if someone is earning less than £150,000, they could still be affected.
This is due to the ‘taper test’, which measures 2 things:
- “Threshold Income” = income (salary, dividends, other income) excluding pension contributions
- “Adjusted Income” = income (as above) but including pension contributions
So put simply, the Tapered Annual Allowance rules have the potential to impact an employee with a threshold income above £110,000 per year and/or an adjusted income above £150,000 per year. Yes, that’s as simple as it gets in our world!
But what if your allowance is reduced and you overpay into your pension?
This would classify as an ‘excess contribution’ above the Tapered Annual Allowance and would result in an income tax charge based on the excess amount at the employee’s marginal rate of income tax, currently 45% for top-rate taxpayers.
Do the maths
The long and short of this is that higher earners need to be aware of the tapered annual allowance. If your income is above £110,000, be careful!
It is becoming increasingly common for employers to restrict the maximum pensions contributions to the ‘minimum Tapered Annual Allowance’ = £10,000 per year. And remember, that includes employee and employer contributions.
Some employers offer an enhanced salary in place of would-be pension contributions. The good news is that its cash paid to you now, the bad news is that you’ll pay tax & NI on it (meaning you’ll lose around half of it). If your employer reduces your pension contributions to £10k pa, make sure to ask about this!
You need to sit down with a spreadsheet and work out your income and allowances. Once you’ve figured out what your allowance is, you can plan to use it, without going over. But be careful of things that can trip you up, like company benefits, which can count towards your adjusted income.
Consider the alternatives
It’s clear that the Government wants to restrict the amount that higher earners can put into pensions. Which makes sense, given how tax-efficient pensions are.
So if you’re ‘locked out of pensions’, what’s the alternative?
- Carry Forward – Unused Annual Allowance from previous tax years (up to 3 years) can be used to make further contributions into your pension without the prospect of tax charges.
- ISAs – while ISAs don’t quite have the same tax benefits as pensions, they do provide a tax-free pot for your money to grow.
- Venture Capital Trusts – these are HMRC-approved investment vehicles that have several highly attractive tax benefits. They aren’t for everyone though, as they invest in smaller UK companies that carry higher risks.
Hopefully, that gives you some food for thought.
As always, any questions, just drop me a line.
All the best,
James Mackay, Independent Financial Adviser in Bristol