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Income tax relief for pension premiums

Tax relief

Pension contributions made personally by members are limited to 100% of relevant UK earnings for tax relief purposes or £3,600 if higher. They obtain tax relief at the person’s highest marginal rate.

Contributions to an employer’s scheme are usually paid gross and tax relief is given immediately through the PAYE system.

Contributions to personal pension schemes are paid net of basic rate tax. The scheme claims the equivalent of basic rate tax from HMRC, even if the member is a non-taxpayer. If the member is a higher or additional rate tax payer (40% or 45%), the extra tax relief (of 20% or 25%) is claimed via the self-assessment tax return, if the tax coding has not already allowed for it.

The fact that contributions are paid net of basic rate tax can lead to confusion because it is the grossed-up figure that is used for tax relief and annual allowance purposes. For instance, although a person may write a cheque for £20,000 for a personal pension contribution, this is grossed up to £25,000 and so relevant UK earnings need to exceed £25,000 for full tax relief and £25,000 counts for annual allowance purposes, below.

Pension input periods, explained below, have been historically used for testing the contributions against the person’s annual allowance but not for the purposes of tax relief. For tax relief, the important issue is the tax year in which the contribution is actually paid. From 6th April 2016 pension input periods have been aligned with the tax years, which simplifies the situation.

There is no provision for ‘carry back’ i.e. you cannot treat a contribution as being paid in a previous tax year for tax relief purposes.

The employer can obtain full corporation tax relief on its contributions, as long as they are justifiable as a business expense.

There are two other overriding limits on what can be contributed and be eligible for tax relief. These are called the annual allowance (AA) and the money purchase annual allowance (MPAA).

Annual allowance

The annual allowance (AA) is the maximum amount of benefit or total pension input that can build up from contributions (or accrual of benefit) during each pension input period without incurring a tax charge. If the AA is exceeded, an annual allowance charge is payable at the individual’s marginal tax rate of income tax.

The main rules are:

  1. The annual allowance for the 2016/17 tax year is £40,000.
  2. From 6th April 2016 new rules have been introduced whereby the annual allowance is tapered for individuals with an adjusted income of £150,000 or more.
  3. The annual allowance was reduced from £255,000 to £50,000 in 2011/12 tax year and then further reduced to £40,000 from 6th April 2014.
  4. The money purchase annual allowance (MPAA) was introduced on 6th April 2015 and will be triggered when certain events occur (see below), and means that the individual will have an annual allowance of £10,000 with no ability to carry forward any unused allowances from the last three years.
  5. Unless an individual is subject to MPAA, unused annual allowances from the previous three pension input periods can be carried forward (see below).
  6. The annual allowance is subject to change for political reasons.
  7. For active members of defined benefit (final salary) schemes, the total pension input is defined as the increase in the capital value of pension rights over the pension input period (PIP).

In addition, the 2015 Summer Budget introduced transitional rules that enabled individuals to have a maximum annual allowance of £80,000 for 2015/16 tax year in respect of pre-Budget savings. Members also had an annual allowance of up to £40,000 for post-Budget pension input, but the actual amount depended on how much was contributed in the pre-Budget period.

Pension input periods

A pension input period (PIP) is the period over which the amount of pension input (i.e. the total of personal pension or SIPP contributions plus any increase in benefits accrued in a final salary scheme) is measured for the purposes of an annual allowance test to see if an annual allowance tax charge would apply.

Prior to the Summer Budget held on 8th July 2015, the pension input periods of some pensions was dependent on the date the contract was originally set up. So somebody could have had a pension input running from 1st July to 30th June each year. Their total input was then measured against the annual allowance applicable to the tax year in which the PIP ended.

Previous rules were complicated as individuals who held a number of pension plans could have different PIPs with different providers therefore working out the maximum contribution they could make could become very complex. To simplify this, the Summer Budget 2015 confirmed that from 6th April 2016 all PIPs now run between 6th April and 5th April each year, i.e. in line with the tax year.

Tapered annual allowance

From 6th April 2016 new rules came into force whereby those with adjusted income (which includes all income as well as their own and their employer’s pension contributions) above £150,000 will see their £40,000 annual allowance for 2016/17 reduced on a tapered basis.

For every £2 of adjusted income over £150,000, the annual allowance will be reduced by £1, down to a minimum of £10,000. The inclusion of employer pension contributions in the definition of adjusted income means that it is not possible to use salary exchange to reduce income below £150,000.

Those with threshold income (i.e. all income less pension contributions) of £110,000 or less will not be subject to tapered annual allowance.

Carry forward can still be used by an individual who is subject to a tapered annual allowance, and this will be up to £50,000 in respect of 2013/14, and £40,000 each for 2014/15 and 2015/16 tax years (assuming the money purchase annual allowance does not apply). For the tax years 2016/17 on onwards the amount of carry forward available will be based on the unused tapered annual allowance.

Carry forward of unused annual allowance

Annual allowance unused in one pension input period can be carried forward to subsequent years, for up to three years. To be eligible to carry forward, you must have been a member of a registered pension scheme at some point during the tax year from which you wish to carry forward unused annual allowance. There is no requirement to have paid contributions in those earlier tax years.

The current tax year’s annual allowance has to be used first, so carrying forward to 2016/17 would only be necessary if the current tax year’s contribution is in excess of £40,000 (or the person’s tapered annual allowance where this applies).

A carry forward exercise then begins by using up any unused annual allowance from the earliest carry forward year first (i.e. for 2016/17, once the £40,000 has been fully used up, anything unused from 2013/14 would be utilised first).

Unused allowances are lost if they have not been used in the following three tax years.

Money purchase annual allowance

If MPAA rules are triggered, the individual will have a £10,000 annual allowance for all their money purchase savings (i.e. contributions into SIPPs and individual and group personal pensions). The main events that trigger MPAA include:

  • Drawing benefits from pension plans using flexi-access drawdown, short-term annuities or by withdrawing a cash lump sum of which 75% is subject to income tax; or
  • Converting an existing capped drawdown pension into a new flexi-access drawdown or taking income above the maximum permitted under an existing capped drawdown plan; or
  • Receiving an income from a flexible annuity where the annual payment can be varied.

Taking tax free cash only (without drawing any taxable income) from a pension will not trigger an MPAA. Also, MPAA does not apply to the pension accrual in final salary schemes.

You cannot carry forward unused MPAA and it is never possible to have an MPAA that exceeds £10,000 in any one tax year.

Exceeding the annual allowance or the money purchase annual allowance

The total of all contributions in a tax year is compared against the individual’s annual allowance or money purchase annual allowance. If this total exceeds the current tax year’s allowance plus, in case of a person who is not subject to MPAA, unused allowances carried forward from the three previous tax years, the excess is taxed as if it were added to the member’s earnings i.e. at 20%, 40 or 45%.

Most commonly, the excess is declared on the person’s tax return and the tax is paid under the normal self-assessment rules. In some circumstances, it may be possible for the scheme administrator to pay the annual allowance charge on behalf of the member. In this case, an appropriate reduction would be made to the person’s pension benefits.

The excess contribution or pension accrual remains in the pension scheme. It is not distinguished from other funds in the scheme and is used to provide benefits in the normal way. Any pension income eventually drawn is taxed as income and so, if the annual allowance is exceeded, the excess is taxed twice. As a result, it will be unlikely that anyone will consciously want to make contributions to money purchase schemes in excess of the annual allowance.

Examples

Example 1: Pension input below annual allowance limit

Simon has a total income of £60,000. He pays personal contributions totalling £10,000 gross (i.e. a cheque for £8,000) and his employer pays contributions of £25,000 in 2016/17 tax year. The total contribution is £35,000.

Simon’s personal contribution is less than 100% of his relevant UK earnings. Both Simon and his employer receive full tax relief on their contributions. The total contribution is less than the annual allowance so there is no need to consider carry forward and no tax charge is due.

Example 2: Carry forward

Stephanie has several personal pension schemes and a SSAS. All arrangements have always had pension input periods in line with the tax years. She wants to pay the maximum contribution for the 2016/17 tax year.

Her total gross contributions (employer and employee) for the tax years 2013/14, 2014/15 and 2015/16 were £10,000, £40,000 and £20,000 respectively. Her unused allowances that can be carried forward are therefore £40,000, nil and £20,000, giving a total of £60,000.

Adding the carried forward allowances of £60,000 to the current year’s allowance of £40,000 means that Stephanie could make a total contribution of £100,000.

Her earnings are £60,000 with no other income, so she is not subject to tapered annual allowance. The maximum she could pay personally is £48,000 net (i.e. £60,000 when grossed up). Her employer could pay the balance.

If Stephanie and her employer decided to pay a total of £80,000, she would use up her current year’s annual allowance of £40,000 and £40,000 would be carried forward from 2013/14 tax year, which would otherwise be lost if not used by 5th April 2017.

Alternatively, if Stephanie and her employer decided to pay a total of £40,000, then she would use up her current year’s Annual Allowance of £40,000 and would not need to carry forward any unused allowances. She would lose the unused allowance of £40,000 from 2013/14. In the next tax year2017/18, she would have nothing to carry forward from 2014/15 and 2016/17 with only £20,000 unused from 2015/16.

Example 3: Carry forward not available

Shaun and Nigel are brother. They recently received an inheritance which they would like to use to maximise their pension contributions. Shaun, who has never previously had any pension arrangements, decides to set up a personal pension in the 2016/17 tax year. The maximum he can contribute and not suffer an annual allowance tax charge is limited to £40,000 because no allowances can be carried forward from the years in which he was not a member of a registered pension scheme.

Nigel has a small pension into which he paid £1,000 in the tax year 2011/12. Although he did not pay any contributions in subsequent years, he has been a member of a pension scheme and is eligible to carry forward unused allowances from the last three tax years. He can make a total contribution of £170,000 in 2016/17 tax year.

Example 4: Tapered annual allowance

Phil is a company director and sole shareholder of his own company. His taxable income is £100,000 and he decides to pay an employer contribution of £60,000 (using carry forward to avoid an annual allowance charge).

His adjusted income is therefore £160,000 which would on the face of it trigger a reduction of £5,000 in his annual allowance (half of the £10,000 excess over £150,000). However, his threshold income is only £100,000 and so the tapered reduction does not apply.

If Phil’s total taxable income was £120,000 and his adjusted income £180,000, his annual allowance would be reduced by £30,000/2 = £15,000 to £25,000 for 2016/17 tax year.

Example 5: Money purchase annual allowance

Robert, aged 59, has a SIPP. This is his only pension and he is not subject to the tapered annual allowance in 2016/17 tax year. He reaches his 60th birthday on 1st December 2016 when he intends to semi-retire and start accessing his pension using flexi-access drawdown. Over the recent years, in preparation for his retirement, he has made maximum contributions up to his annual allowance. As a result he has no carry forward available.

Robert has not made a contribution in respect of the 2016/17 pension input period. By taking income from his pension under flexi-access drawdown he will trigger a money purchase annual allowance in December 2016.Therefore, he pays a single contribution of £40,000 into his SIPP in October 2016, i.e. before the trigger event. As this is within his annual allowance, no tax charge would be due.

Had he waited and made the contribution in January 2017 (i.e. after the trigger event), he would be assessed against the money purchase annual allowance of £10,000. In subsequent tax years, if Robert has sufficient relevant UK earnings and wishes to pay into his pension, he will be subject to the £10,000 money purchase annual allowance. He will not be able to carry forward any future unused allowances.

Forward planning

Any taxpayer with income in excess of £100,000 could find that their pension contributions receive an effective rate of tax relief of 60% due to the tapering of the personal allowance.

In general, you should try to use up this tax year’s annual allowance plus any unused allowance from three years ago before you lose it.

If you do not have any pension arrangements at all but think that you will be in a position to make large contributions in the future, you should consider paying a token contribution to a scheme to start your annual allowance accruing for carry forward purposes.

It’s also worth remembering that dividends are not included within the definition of relevant UK earnings. Therefore, drawing a large proportion of earnings are dividends may restrict the amount of tax relief you can claim on your individual contributions.

FOR GENERAL INFORMATION ONLY

Please note that this Memorandum is not intended to give specific technical advice and it should not be construed as doing so. It is designed to merely alert clients to some of the issues. It is not intended to give exhaustive coverage of the topic.

Professional advice should always be sought before action is either taken or refrained from as a result of information contained herein.

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