Tax relief and the annual allowance
Jim Grant and Jennifer Irvine dig deeper into the technicalities of tax relief and the annual allowance in our webinar master-class.
This webinar was recorded on 17 May 2023 and figures are based on the 2023/24 tax year.
CPD learning outcomes
- Understand the rules on tax relief and how much is available
- Understand the relationship between the annual allowance and tax relief
- Understand what triggers the money purchase annual allowance
- Understand how to calculate the annual allowance when the taper applies
- Understand how to calculate unused annual allowance using carry forward.
- Tax relief on contributions with examples
- What will and won't trigger the money purchase annual allowance
- Definitions of threshold income and adjusted income with examples
- Carry forward - where it can go wrong.
Hi, I'm Jennifer Irvine and I'm a Pensions Technical Consultant at Royal London. I'm here with Jim Grant and we're going to talk about tax relief and annual allowance at this session. When it comes to planning for the future, we believe all customers need to be better prepared and better informed. To us, this is best achieved when advisors and providers work closer together – it’s a key step towards delivering better outcomes.
The next slide shows the learning objectives of the session. These are to have an understanding of:
• the rules on tax relief and how much is available.
• the relationship between the annual allowance and tax relief.
• what triggers the money purchase annual allowance?
• how to calculate the annual allowance when the taper applies, and
• how to calculate unused annual allowance using carry forward.
So let's look at the first bullet point, the rules on tax relief.
An employer contribution is paid gross and the corporation tax relief is claimed by deducting the contribution from tax relief from taxable profits at the expense of the business.
In theory, HMRC will accept any level of contribution as being the expense of the business, so long as it has made wholly and exclusively for the purpose of the trade or profession. There's a lot of rules and examples of what this means on HMRC's website, but essentially they're designed to make sure that the rules on corporation tax relief aren't abused. For example, by making a contribution for a close relative of a controlling director that's out of proportion to the worth to the company, individuals get tax relief on their contributions within limits, either by the relief at source system or the net pay arrangement. Let's look how tax relief on member contributions is given in a little more detail in the next slide.
To qualify for tax relief, an individual must be a relevant UK individual. This means that they must either:
• have relevant UK earnings chargeable to income tax for that tax year, or
• be resident in the UK at sometime during that tax year, or
• have been resident in the UK at sometime during the five previous tax years and when they joined the pension scheme.
That last bit allows people going abroad to continue paying tax reliable member contributions to their pension scheme for up to five years after leaving the UK. Assuming they don't have relevant UK earnings. Tax relief will be restricted to £3,600 a year gross. Relevant UK earnings are basically employed or self-employed earnings that are subject to UK income tax. If a relevant UK individual does have relevant UK earnings, the maximum tax reliable contribution they can pay is a higher of £3,600 a year and 100% of UK earnings in the tax year.
Royal London can't accept new applications from anybody who isn't habitually resident in the UK.
If they're already a member of a Royal London plan, we can continue to accept contributions at the existing level to that plan. Up to £3,600 gross less any contributions they may be making to other pension schemes for up to five tax years after the tax year they left the UK.
Relief at source is a method used to give tax relief on contributions to non-occupational schemes such as personal pensions. There are circumstances in which it could be used with occupational schemes as well, but these normally use the net pay arrangement which we deal with later. Basic rate tax relief is given by the provider adding basic rate tax relief, currently 20% of the gross contribution, to the net contribution and claiming that tax relief from HMRC. So, someone paying a gross contribution of £100 will actually only pay £80 out of their own pocket with the tax man paying £20. Since the 20% tax relief is based on the gross contribution, this results in tax relief increasing the net contribution by 25% as £20 is 25% of £80.
If someone pays income tax at a higher rate than 20%, they can claim the difference between basic rate and whatever higher rate they're paying via the tax return or by writing to HMRC. Taxpayers in England, Wales and Northern Ireland can pay tax at 20%, 40% and 45%. In Scotland, it can be 19%, 20%, 21%, 42% and 47%. It’s important to the member that under relief its source higher rate tax relief has to be claimed. It's not given automatically.
Reasonably enough, however, you can only get this extra tax relief to the extent that they paid tax at this level. In other words, if someone paid tax at 40% on £1,000 of their taxable income and paid a gross contribution of £3,000, they’d only get higher rate tax relief on the £1,000 of the contribution. The higher rate tax relief is actually given by extending the basic rate tax band by the amount of the gross contribution. This means that it can also help reduce the tax during investments such as investment bonds. But that's another story!
Now let's have a look at example. If someone has taxable income of £51,270 and the 23/24 tax year, who will be entitled to a personal allowance of £12,570. They therefore won't pay income tax on the first £12,570 of their taxable income.
In England, Wales and Northern Ireland, they'll pay tax at the basic rate of 20% on the next 37,700 so basic rate tax will amount to £7,540. On the £1,000 balance of their taxable income, they'll pay tax at the higher rate of 40%, producing a tax amount of £400. The total tax bill will therefore be £7,940.
In Scotland, the bands and rates are different, but the principle is the same. For simplicity, in the following slides we won't repeat the calculations to show the situation for Scottish taxpayers.
Now if they pay a member contribution of £1,000, the entitlement to tax relief at the higher rate of tax is given by expanding the basic rate tax band by the gross amount. In this example the basic rate tax band is increased by £1000, so it becomes £38,700.
The basic rate tax payable on £38,700 now becomes £7,740 and no part of the taxable income is taxed at the higher rate. The total tax bill is now reduced to £7,740 and they've saved £200 in tax.
Remember, the individual has already had £200 of basic rate tax relief at source by paying a net contribution of £800. So they have effectively received tax relief of £400, which is 40% of the gross contribution of £1,000. In other words, they've had full higher rate tax relief on all of the gross contribution.
If the individual makes a pension contribution of £3,000, the basic rate tax band is again expanded by the gross amount. In this case, the basic rate tax band is expanded from £37,700 to £40,700, although as their taxable income is only £51,270, basic rate tax will apply to £38,700 of their income. That's £51,270 minus the £12,570.
However, before the contribution was made, the individual was only paying higher rate income tax on £1,000 pound income above 50,270. So, they are only entitled to receive higher rate additional tax relief on the £1,000 of the £3,000 pension contribution. This is because only £1,000 of the individual’s taxable income will have been taxed at the higher rate had the pension contribution not been paid. You can therefore see that the individuals total tax bill is still £7,740, which is £200 less than if no pension contribution have been paid. However, a further tax saving of £600 will have been received when the individual paid their net contribution of £2,400 i.e. 80% of the £3,000,
By making a pension contribution of £3,000 the individual has therefore received tax relief of £800 on their contribution, which represents 26.67% of the £3,000 gross contribution. This is less than 40% because the individual would only have been entitled to higher rate tax relief on £1,000, the amount of taxable income that would have been in the higher rate tax band if no pension contribution had been made.
Another method of claiming tax relief on member contributions is by net pay. The net pay arrangement is only available to members of occupational schemes. Under this method, the employer deducts the member contribution from the employer's salary or pay before deducting income tax. In this way higher and additional rate taxpayers get immediate tax relief at their marginal rate. The individuals don't get any more tax relief than is available under the relief at source method but they don't have to claim any tax relief through the tax return - it's received immediately through a reduced taxable income.
It does mean, however, that currently those who don't pay income tax, at least at the level of the member pension contribution, miss out on the tax relief they would have had if the relief at source system was used. However, from tax year 24/25, those in that position will receive a top up payment paid direct directly to them from HMRC.
National Insurance contributions are still based on the pre-contribution salary, however, only salary exchange arrangements escape National Insurance contributions.
Now let's look at the annual allowance. The annual allowance effectively limits the amount of total pension contributions that can be paid in a pension plan without a tax charge applying.
The maximum that can be paid by or for an individual within the annual allowance is 60,000 over the pension input. The PIP, as we'll call it from now on, is now aligned with the tax year.
Another important point is that the annual allowance isn't a limit per plan – it applies to total pension contributions paid to all plans. What the annual allowance does is basically cap the tax relief by imposing an annual allowance charge through the individual’s tax return. Employer, member and 3rd party contributions all count towards the annual allowance, but it's a member who's liable for any charge.
As we've seen the tax relief rules mean that someone with UK earnings of £60,000 in that tax year could pay a gross contribution up to £60,000 over that tax year and get tax relief on that. If the relief at source system is being used, that means paying a net amount of £48,000 with basic rate tax relief of £12,000 being added by the provider and claimed from HMRC. Again, as we've seen further tax relief on the part of the contribution that lies in the higher rate and additional rate tax bands can be claimed through their tax return or by writing to HMRC.
However, although tax relief is given on the gross contribution of £60,000, an annual allowance charge is payable on £20,000, that is a pension contribution of £60,000 less annual allowance of £40,000. The amount of the charges is at the member’s marginal tax rate and so it's designed to remove all tax relief from the excess contributions. If there is unused annual allowance from the previous three tax years, this can be carried forward to boost the amount of annual allowance. Again available. Sorry again, we'll look later at how this works.
The pension input amount is the amount paid into the plan or the value of benefits accrued over the PIP that's measured against the annual allowance available. For money purchase schemes it’s very straightforward – it’s the amount of contributions paid over the PIP, whether that be member contributions, employer contributions, third party contributions or the mix.
For defined benefit schemes, it's more complicated and we'll go on to discuss this in the next slide.
So for a defined benefit scheme, start by calculating the amount of pension accrued at the beginning of the PIP and multiplied by 16. If the tax-free cash builds up separately as it does in some public sector schemes, add this on.
Increase this total by the appropriate CPI increase. The CPI rate you use is the annual rate for the September before the start of the PIP. This is the adjusted opening value we've got.
Then calculate the accrued pension value at the end of the PIP and multiply it by 16. Add any tax fee cash that builds up separately. This is the closing value you've got.
Finally, deduct the adjusted opening value from the closing value.
Given the complexity of this calculation and the knowledge of the scheme rules required, it’s safer to rely on a pension savings statement from the scheme. You'll have to the request this if the pension input amount for the scheme is less than the annual allowance. You'll have to estimate it for the current year as the scheme won't have this information until the end of the tax year.
However, full details of the calculation can be found in Technical Central.
Now we're going to discuss the money purchase annual allowance. The money purchase annual allowance further restricts the contributions that could be paid to money purchase schemes.
We'll see in a minute what events trigger the money purchase annual allowance, but if it is triggered, the maximum amount that can be paid to money purchase schemes without incurring an annual allowance charge is £10,000 and once triggered applies for life.
It operates over the same PIP as the ordinary annual allowance, and the amount of the charge is again the individual's marginal rate of income tax.
However, unlike the ordinary annual allowance, carry forward of unused money purchase annual allowance from previous PIPs can't be used to boost the amount of money purchase annual allowance available. As it name suggests the money purchase annual allowance doesn't affect defined benefit schemes.
There are different scenarios that can trigger the money purchase annual allowance. The most common of these being:
• taking income from a capped drawdown plan that exceeds the CAD limit,
• receiving a lump sum from uncrystallised funds, i.e., taking UFPLS
• taking income payments from a flexi access drawdown plan.
The following wouldn’t trigger the money purchase annual allowance:
• taking income from a capped drawdown plan that's within the GAD limit,
• additional fund designation to an existing capped drawdown plan,
• Receiving a scheme pension from an occupational pension scheme,
• receiving tax free cash only,
• taking a small pot lump sum.
• trivial commutation under defined benefits scheme.
• buying a lifetime annuity.
So, to give an example of how this works, if John has triggered the money purchase annual allowance and pays contributions to schemes of £9,000, his £51,000 annual allowance left of which a further £1,000 can be paid to money purchase schemes.
If he paid contributions of £12,000 to money purchase schemes, there will be an annual allowance charging on the £2,000 excess and there will be £50,000 of annual allowance available for pension savings in defined benefit schemes.
For tax year 23/24, those with adjusted income of £260,000 or more and the tax year have the annual allowance reduced.
The reduction is at the rate of £1 for every £2 by which adjusted income exceeds £260,000.
The annual allowance can't reduce below £10,000, so anyone with adjusted income of £360,000 or more will have an annual allowance of £10,000. However, the taper doesn't apply with a threshold income is £200,000 or less.
To make sense of all this, we obviously need to know that the terms threshold income and adjusted income mean.
The starting point of both terms is taxable income. This can be complicated where individuals are eligible for all sorts of relief and allowances and may need the input of their accountant, but for most it's relatively straightforward. It would include things like salary, commission, bonus, overtime, shift allowances and any taxable investment income they have, including rental income.
From there you can calculate threshold and adjusted income. The main difference between them being that threshold income includes no pension contributions, whereas adjusted income includes all pension contributions.
Some individuals could have relatively low income and relatively high pension contributions.
HMRC has made clear it's not the intention to restrict the annual allowance for individuals where a relatively high proportion of their adjusted income is made-up of pension contributions.
So, that is why there is an income floor below which the reduction doesn't apply. This is called the threshold income and it's currently £200,000.
As mentioned, the starting point is taxable income. You can deduct any tax lump sum death benefit received in the tax year but if the salary exchange agreement is set up on or after 9th of July 2015 and it's reasonable to assume that the purpose of the salary exchange agreement was to reduce threshold income. The employment income given up has to be added back in.
Member contributions are usually already included in the taxable income amount. When someone says their salary is £160,000, you don't usually mean that that's their income after pension contributions have been deducted. Any gross personal contributions paid, whether by the relief at source system or the net pay arrangement, can be deducted. So an individual could pay more member pension contributions to our personal pension, or additional voluntary contributions to an occupational pension scheme to reduce their threshold income.
If the threshold income isn't exceeded, there's no need to go any further. The taper doesn't apply. If it has exceeded, you know you need to go on to look at adjusted income.
For adjusted income, the starting point is again taxable income, but adjusted income includes pension contributions.
As before, member contributions are usually already included in the taxable income of mine, but you also have to add any employer contributions is adjusted income includes all pension contributions.
Finally, if the individual received a taxed lump sum death benefit in the tax year, this can be deducted. If the final amount exceeds £260,000 and the taper applies to this individual, the annual allowance will reduce by a £1 for each £2 excess. The annual allowance can't however reduce to below £10,000, which means that £10,000 is the reduced annual allowance for everyone with adjusted income of 360,000 or more.
A diagram may make this clearer. For threshold income you:
• deduct gross member contributions paid.
• add any employment income given through a salary exchange agreement set up after the 8th of July 2015, and
• deduct any taxed lump sum death benefits
For adjusted income, you add any employer contributions and deduct any taxed lump sum death benefits.
It's worth noting that the employer contribution for a defined benefit scheme is deemed to be the pension input amount less any member contributions.
Now let's look at example. Mike has a salary of 270,000 a year, an investment income of 10,000 a year.
He pays £12,500 a year to his occupational pension scheme under the net pay arrangement and his employer pays £17,500.
Would his annual allowance reduce, and if so, to what level?
First, we'll look at Mike's threshold income. If it is 200,000 or less, his annual allowance won't be reduced.
However, as it stands, his threshold income is his £270,000 salary plus his investment income of £10,000, less his contributions of 12,500, so £267,500. Although the employer's pension contribution of 17,500 isn't included, he's still well over the limit of £200,000 and it's possible that the tapered annual reduction will apply.
If he paid a net contribution of £54,000, this would be grossed up to £67,500 and would be enough to get him down to the required level.
However, such a payment on top of the existing total employer and member pension contribution of £30,000 will bring pension contributions up to £97,500. He’d therefore need at least £37,500 of unused annual allowance to carry forward in order to avoid an annual allowance charge.
Now for his adjusted income.
The £270,000 is Mike's earnings before the deduction of his £12,500 contribution to his occupational pension scheme, so there's no need to add it back in again. We do however, need to include his £10,000 of investment income and the employer contribution of £17,500. This totals 297,500, which is £37,500 over the £260,000 limit.
His annual allowance will therefore be reduced by half of this and so £18,750 will be deducted from the standard annual allowance of £60,000, resulting in the annual allowance of £41,250.
And now in the next slide.
We've seen member, employer and 3rd party contributions all count towards the annual allowance and that in defined benefit schemes it’s the value of the benefits accrued over the year. Any excess of the pension input amount over the annual allowance available attracts an annual allowance charge.
It’s the individual that pays the charge though, regardless of the source of the pension input amount. Any excess contribution is added to the individual’s taxable income to see what the marginal rate of tax would be on that basis and this is then the rate of annual allowance charge applied to the excess. This is all done through the tax return and the aim is to remove the tax relief on the excess contributions.
It's also possible for the individual to pay the charge out their pension pot, known as scheme pays. If the charges is more than £2,000 and the pension input amount for that pension scheme is more than £60,000, the scheme must apply scheme pays on request. If the conditions aren't met, the scheme can apply scheme pays voluntarily if asked, but not many schemes do this.
And now over to Jim Grant who's going to talk about some carry forward examples. Thanks.
Thank you, Jennifer. Jim Grant here, another technical consultant at Royal London and we're going to have a look at some of the aspects of carry forward, things to look out for and things to avoid, right. OK. So by the end of the session, the learning points we hope to achieve is that you'll know where people go wrong when doing carry forward calculations and how to prepare. You also understand carry forward by working through some case studies.
So carry forward. Where do people go wrong? First of all, they get mixed up between annual allowance and tax relief. They may forget about the taper or the money purchase annual allowance.
They don't handle employer contributions or a previous carry forward correctly. They get confused about the eligibility for carry forward. And lastly, they try to do DB calculations themselves. As we've seen these can be quite complex.
So, what do you need in advance? You need to establish the eligibility for carry forward. You need to have current earnings. Possibly 2020/21, 2021/22 and 22/23 as well. And that's to check if the taper applies the contribution history from at least 2000 and 2021 onwards, plus earlier if previous carry forward applies. And you'll need a table to record contributions paid and an annual allowance used for each tax year. And we prefer tables rather than any other means of doing this because it's much clearer.
So, let's look at the first carry forward example and my apologies for reading this out, but just make sure we're all at the same point. But Sam has his own limited liability company and in 2023/24 he'll pay himself a salary of £5,000 and dividends of £100,000.
He took out a personal pension plan on the 1st of August 2012. And he's been saving £1,200 a month in employer contributions ever since. He's got no other retirement savings and wants to make a substantial single contribution before the end of the 2023/24 tax year. Sam wants to know how much he can contribute without triggering an annual allowance charge. He hasn't triggered the money purchase annual allowance, and the taper deduction of annual allowance for people with high income doesn't apply.
So let's have a look at the at the calculations just taking them through from the beginning from in 2020/21, the annual allowance is 40,000, total contributions were £14,400 and therefore has carry forward available of £25,600. And for the next three tax years they're exactly the same - annual allowance £40,000, contributions £14,400 and carry forward available from that tax year £25,600. But in 2023/24, it's slightly different because the annual allowance went up to £60,000. It's still total contributions of £14,400 assuming that the contributions continue to the end of the tax year. The amount of annual allowance available for 2023/24 is therefore £45,600, totalling £122,400.
So he could make an additional employer contribution of up to £122,400 without incurring an annual annual charge. If he paid it as a member contribution, he wouldn't get tax relief because his earnings are only £5000.
Carry forward Example 2. Amy is the finance director of a large manufacturing company. Earning £230,000 in the 2023/24 tax year, her employer has been making single contributions into a group personal pension plan for her since 1st of May 2011. She hasn't been contributing herself, doesn't have any other retirement savings. Her employer will make a contribution of £33,400 in 2023/24.
She wants to make a large single contribution before the end of the 2023/24 tax year. She wants to know how much she can contribute without triggering an annual allowance charge. She hasn't triggered the money purchased annual allowance, but the tapered reduction of annual loans may apply because of her earnings and her employer's pension contribution, but it hasn't applied in previous years.
OK, so looking at the calcs.
2020/21 £40,000 annual allowance, total contributions £21,600 giving £18,400 carry forward available. 2021/22 annual allowance again £40,000, contributions £22,200, £17,800 carry forward available and for 2022/23, annual allowance £40,000, total contributions £22,800 giving carry forward available of 17,200. In 2023/24, annual allowance of £60,000, total contributions are £33,400. Giving an amount of annual allowance available for 2023/24 of £26,600. That all totals £80,000. So if Amy makes an individual gross contribution of £80,000, this will reduce our threshold income to £150,000.
This means her annual allowance will be £60,000 for 2023/24 as a taper will not apply, The payment of £80,000 is within her earnings for the tax year and will receive tax relief at her marginal rate.
And for our final example, we've got Brian who's a partner in an accountancy firm. He'll earn £110,000 in the 2023/24 tax year.
He's been making occasional single contributions into personal pension plan since September 2019 and he's already contributed £25,000 in 2023/24. He's never been a member of any other pension scheme, now wants to make a substantial further single contribution before the end of the 2023/24 tax year. He wants to know how much he can contribute without triggering an annual allowance charge. He hasn't triggered the money purchase annual allowance and the taper reduction of annual allowance for people with high income doesn't apply.
So if you look at the calculations here, we'll see that a total of £45,000 unused annual was available in 2021/22 from 2019/20 and 2020/21.
The £20,000 excess over the annual allowance that was paid in 2021/22 is covered by the £20,000 carry forward from 2019/20. So the £25,000 carry forward from 2020/21 is still available to be used in 2023/24. The £20,000 carry forward from 2019/20 is shown in teal to indicate that it's not available for use in 2023/24.
So after paying the single contribution of £25,000 in tax year 2023/24, a further member contribution of up to £80,000 that's £25,000 plus £20,000 plus £35,000 can be paid before the end of the tax year without an annual allowance charge applying. This total contribution is within Brian's earnings and so will be eligible for tax relief. Another point to make is that if Brian had had carry forward from 2018/19 that could have been used to partially or completely offset the excess in 2021/22. That would mean that more carry forward would be available in 2023/24. If it completely offset the excess that would have meant another £20,000 of carry forward could be used in 2023/24 giving a further £100,000 that could be paid without an annual allowance charge applying. This is less than his earnings and so again would be eligible for tax relief.
OK, we've gone over a fair bit of ground here. The concepts themselves are actually reasonably straightforward, although the practical aspects of them can be complex, especially if an individual is a member of a number of pension schemes or has taper issues in the current tax year and or previous years. The main points rather are that tax relief for member contributions and pension input periods operate over the tax year. It's possible to pay a pension to pay a contribution that gets tax relief.
or which also attracts the annual loans charge. Carry forward can boost the annual allowance available and any annual allowance charge is paid by the individual, although they might be able to pay the charge out of their pension pot. The money purchase annual allowance can cut contributions to money purchase plans, without an annual allowance charge applying to £10,000 a year and high earners can have a taper deduction in their annual allowance and that's it.
I hope you found this presentation useful and that you now have a better understanding of how tax relief and the annual allowance interact. A copy of this presentation can be found in the CPD and Webinar section of Technical Central. Thank you.
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