Earlier this year we had changes to the rules which govern the amount which can be paid into pensions without incurring tax penalties. We thought it might be useful to take a look at the new rules and what it might mean for those looking to maximise this tax-efficient method of saving for retirement:
What is the annual allowance?
It is the limit on how much can be contributed into your pension and still receive tax relief. It is currently set at £40,000, but depending on your earnings, this may be reduced (tapering). Where annual allowances are exceeded, tax penalties are applied, the effect of which is to remove the valuable tax relief.
What is the Tapered Annual Allowance (TAA) and what were the old rules?
The TAA was introduced in 2016. It reduced the annual allowance by £1 for every £2 of “adjusted income” (gross income, including dividends, interest and other non-employment income plus all employer pension contributions) above the limit of £150,000pa.
The TAA only applied for those with “threshold income” (overall gross taxable income less gross member pension contributions) greater than £110,000.
The TAA was limited to a £30,000 maximum reduction. This effectively meant that for those earning £210,000 or more the amount of gross contributions upon which tax relief could be received was reduced to £10,000.
What are the new rules?
From the current 2020/21 tax year, the threshold income and overall adjusted income thresholds have changed to £200,000 and £240,000 respectively (previously £110,000 and £150,000 respectively). The TAA will only apply when both of these thresholds are exceeded.
However, whilst the limits have been extended which is good news, the reductions now go further. The TAA is now limited to a maximum £36,000 reduction which results in an annual allowance of £4,000 for anyone with adjusted income of £312,000pa.
What does this mean for you?
If you have an adjusted income of £150,000 - £240,000 you can now claim tax relief on a maximum contribution of £40,000 into your pension (assuming no carry forward). This will mean a significant extension of pension contribution limits for some. Those with an adjusted income of £312,000 or greater can only make a £4,000 contribution (plus any available unused allowances carried forward). This means the highest earners will see a reduction in their contribution limits from £10,000 to £4,000.
Defined Benefit Arrangements
The annual allowance applies to both money purchase and defined benefit arrangements. However, rather than the amount of the contribution being tested against the annual or tapered annual allowance, it is the amount by which entitlement to benefits has increased. This adds a further complication to the calculation and warrants a separate article for the explanation!
In our view pensions remain the most tax-efficient wrapper for long term investments. The rules, however, can be complex and care is needed to avoid tax charges which can negate lots of the good work done in accumulating and putting these funds aside for the future. If you would like to discuss how the new rules might impact your financial plan, we would love to hear from you.