Higher earner? Act now before annual pension allowance cut
What is the annual allowance?
The annual allowance is the total amount of money you can pay into your pension pot every year, including contributions from your employer into a defined benefit or defined contribution scheme, tax-free. You get tax relief from the government on pension contributions up to this limit. Any contributions above the threshold are subject to income tax at your marginal rate.
The annual allowance is currently set at £40,000 a year for everyone. It has already been reduced – it was £50,000 for the tax years between 2011 and 2014.
New tapered annual allowance to hit higher earners
In the Summer Budget 2015, the government announced its intent to cut pensions tax relief for high earners by introducing a tapered annual allowance for those with incomes over £150,000.
The tapered annual allowance comes into effect on 6 April 2016.
What counts as income?
Income includes any money you make including dividends, bank interest, rental income, bonuses and unapproved share schemes.
Will this affect me?
As the current annual allowance is set at £40,000, anyone with an ‘adjusted income’ of between £150,000 and £210,000 will be affected.
Adjusted income is any taxable income minus certain reliefs but includes employer pension contributions and contributions made via salary sacrifice. It’s included to stop people avoiding the annual restriction by exchanging salary for employer contributions.
However, if your salary is lower than this amount but you have a spike in your employer pension contributions, say because you received a bonus and the percentage is matched by your company, the government’s also introducing the ‘threshold income’ test.
If you have a net income threshold of £110,000 or more, excluding personal pension contributions, you may also be in scope for the taper. Under this amount, the new tapering rules won’t apply.
“For the purpose of the threshold test, income includes non-earned income such as dividends and property income; it also includes any salary sacrifice arrangement entered into on or after 9 July 2015 but any personal contributions to a pension can be deducted, as well as a variety of trading reliefs, property loss reliefs and payments to trade unions,” says Nathan Long, senior pension analyst at Hargreaves Lansdown.
How will the tapered annual allowance work?
For higher earners, the annual allowance will be reduced by £1 for every £2 of income above this threshold.
Once adjusted income exceeds £210,000 the annual allowance bottoms out at £10,000.
In the worst case scenario, someone could lose £30,000 of annual allowance, resulting in them having to pay a tax bill of £13,500 (45% tax on an excess contribution of £30,000).
I’m a higher earner, what steps should I take now?
As the taper impacts higher earners and the income includes variable payments as listed above, it will be “absolutely impossible” for the employer to know an employee’s total income in advance of the end of the tax year and it will also be very challenging for many individuals to know their total income, says Long.
“This in turn means they won’t know for sure what their annual allowance for the year is until after the end of the year.
“High earners will now need either a crystal ball or the benefit of hindsight to navigate the new annual allowances rules. Few people know their total year’s income from work, savings and investments in advance. However, those with total annual income above or around £150,000 need to be alive to these changes, or else risk a nasty tax surprise,” he adds.
Here are seven steps higher earners can take, courtesy of Hargreaves Lansdown, to mitigate their pension tax bill: