Tax relief and the annual allowance

Jennifer Irvine:

Hi, I’m Jennifer Irvine and I’m a Pension Technical Consultant in Royal London. I’m here with Jim Grant and we’re going to talk about tax relief and annual allowance at this session.

This slide shows the learning objectives of this 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
• how to calculate unused annual allowance using carry forward

Now, 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 taxable profits as an expense of the business.

In theory, HMRC will accept any level of contribution as being an expense of the business so long as it is 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 their 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 at how tax relief on member contributions is given in a little more detail.

To qualify for tax relief, an individual must be a relevant UK individual. This means they must either:

• have relevant UK earnings chargeable to income tax for that tax year, or
• be resident in the UK at some time during that tax year, or
• have been resident in the UK at some time during the five previous tax years and when they joined the pension scheme. 

That last bit allows people going abroad to continue paying tax relievable member contributions to their pension scheme for up to 5 tax years after leaving the UK.  Assuming they don’t have relevant UK earnings, tax relief will be given on contributions up 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 relievable contribution they can pay is the 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 5 tax years after the tax year they left the UK.

Relief at source is the 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’ll 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 taxman 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 their 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%,45% and 48%.  It’s important to remember that under relief at source, any tax relief higher than 20% has to be claimed – it’s not given automatically.

Reasonably enough however, they can only get this extra tax relief to the extent that they pay 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 £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 due on investments such as investment bonds – but that’s another story!

Let’s have a look at an example.

If someone has taxable income of £51,270 in the 2024/25 tax year they 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.  Their 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.   

If they pay a member contribution of £1,000, their entitlement to tax relief at the higher rate of tax is given by expanding their basic rate tax band by the gross amount.  In this example their basic rate tax band is increased by £1,000 so it becomes £38,700.

The basic rate tax payable on £38,700 now becomes £7,740 and no part of their taxable income is taxed at the higher rate.  Their 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, their 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 (£51,270 - £12,570).

However before the contribution was made, the individual was only paying higher rate income tax on £1,000 income above £50,270 (£12,570 + £37,700). So they are only entitled to receive higher rate additional tax relief on £1,000 of their £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 individual’s total tax bill is still £7,740, which is £200 less than if no pension contribution had 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 £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 their £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 employee’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 their 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 2024/25, those in that position receive a top-up payment paid directly to them from HMRC.

National Insurance contributions are still based on the pre-contribution salary however – only salary sacrifice arrangements escape National Insurance contributions.

Let’s now look at the annual allowance.

The annual allowance effectively limits the amount of total pension contributions that can be paid into 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 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 the member who’s liable for any charge.

As we’ve seen, the tax relief rules mean that someone with UK earnings of £80,000 in the tax year could pay a gross contribution up to £80,000 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 £64,000 with basic rate tax relief of £16,000 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 £80,000, an annual allowance charge is payable on £20,000 (that is the pension contribution of £80,000 less the annual allowance of £60,000).  The amount of the charge is at the member’s marginal tax rate and so is 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 available. 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 tax year 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 tax year, whether that be member contributions, employer contributions, 3rd party contributions or a 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 benefits scheme, start by calculating the amount of pension accrued at the beginning of the tax year and multiply 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 tax year. This is the adjusted opening value.

Then, calculate the accrued pension value at the end of the tax year and multiply it by 16.

Add any tax-free cash that builds up separately. This is the closing value.

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 pensions savings statement from the scheme. You’ll have to 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 can 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, it applies for life.

It operates over the same tax year 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 tax years can’t be used to boost the amount of money purchase annual allowance available.

As its 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 GAD limit.
• Receiving a lump sum from uncrystallised funds (i.e. taking an UFPLS).
• Taking income payments from a flexi-access drawdown plan.

The following won’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 a defined benefit schemes).
• 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.  He has £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 charge on the £2,000 excess and there will be £50,000 of annual allowance available for pensions savings in defined benefit schemes.

 

Now, I going to move onto the topic of the tapered annual allowance.

For 2024/25, those with ‘adjusted income’ of £260,000 or more in the tax year have their 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 an adjusted income of £360,000 or more will have an annual allowance of £10,000.

However the taper doesn’t apply where the ‘threshold income’ is £200,000 or less.

To make sense of all this, we obviously need to know what 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 reliefs and allowances and may need the input of their accountant but for most it’s relatively straight-forward. 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 their 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 taxed lump sum death benefits received in the tax year but if a salary sacrifice agreement is set up on or after 9 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 say £160,000, they 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 a 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 is exceeded, 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 amount but you also have to add any employer contributions as 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, their annual allowance will reduce by £1 for every £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 8 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 an example,

Mike has a salary of £270,000 a year and 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 would 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, £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 an annual allowance of £41,250.

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 of their pension pot (known as ‘scheme pays’).  If the charge 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 many schemes don't do this.

And now over to Jim Grant who is going to talk about some carry forward examples.

 

Jim Grant 
Thank you, Jennifer. Yeah, well, I'm going to go over some case studies now, so we'll have the next slide, please. Jennifer.

So here's the learning points for this part of the webinar. So by the end of this session you'll know:

• where people go wrong when doing carry forward calculations,
• how to prepare for doing carry forward calculations, and
• you'll understand carry forward by working through some case studies.

Next slide please.

So, where do people go wrong? First of all, they get mixed up between annual allowance and tax relief.
Or they forget about the taper or the money purchase annual allowance.
Or, they don't handle employer contributions or a previous carry forward correctly.
They get confused about the eligibility for carry forward.
And they try and do DB calculations themselves, which as I've seen already, can be complex and you're probably better getting that information from the scheme.
Next slide please, Jennifer.

So what do you need in advance? Oh, you need to establish eligibility for carry forward, which is that you've got to be a member of a pension scheme in the tax year that you are carrying forward from. They don't have to be an active member. It can also be a deferred member or,  indeed even, a pensioner member. You've got to be a member of pension scheme in that year.
You also need current earnings to establish whether the taper applies and you possibly need those for 21/22, 22/23 and 23/24 also because the taper could apply in those years as well.

 

You need the contribution history for at least 21/22 onwards plus earlier, if you've got previous carry forward, to increase the complication.

And you’re best to use a table to record contributions paid and annual allowance used for each tax year. I know you can get calculators that can do this but a table sets out really clearly as to what's going in and comparing against the annual allowance for every tax year that you're doing the calculation for.

OK, next slide, Jennifer please.
OK, so here's the first example. My apologies for reading this out. I know it can be annoying, but it means that we're all at the same stage.

So Sam's got his own limited liability company. In 2024/25, he'll pay himself a salary of £5000 and dividends of £100,000. He took out a personal pension plan on the 1st of August 2013 and he's been saving £1,200 a month in employer contributions ever since.
There's no other retirement savings and wants to make a substantial single contribution before the end of the 24/25 tax year. Sam wants to know how much you can contribute without triggering an annual allowance charge. He hasn't triggered the money purchase annual allowance and the tapered reduction of annual allowance for people with high income doesn't apply.

Next slide please.
So just to go through the table there we are from 2021/22. The annual allowance then was £40,000, total contributions at £1200 a month was £14,400. So the carry forward is available for that year is £25,600. And it's the same for all the other years, because nothing's changed so far, so that means that, in total, he could pay an additional £142,400 this tax year, which would be within the annual allowance and therefore wouldn't be subject to annual allowance charge. However, it would have to be an employer contribution because if you recall he's only earning £5,000 a year, he's taking the rest in dividends.

Next slide please.
So here's Amy. Amy is a finance director of a large manufacturing company, earning £230,000 pounds in the 24/25 tax year.
Her employer has been making single contributions into a group personal pension plan for her since 1st of May 2012.
She hasn't been contributing herself and doesn't have any other retirement savings.
Her employer will make a contribution of £33,400 in 2024/25. She wants to make a large single contribution before the end of the 24/25 tax year.
She wants to know how much you can contribute without triggering an annual allowance charge. She hasn't triggered the money purchase annual allowance, but the taper reduction of annual allowance may apply because of her earnings and her employer’s pension contribution. It hasn't applied in previous years.

So next slide please.
So here's the chart for Amy setting out the carry forward of every year from 2021/22 to the current tax year, which totals £80,000.
If Amy makes an individual gross contribution of £80,000. That would reduce our threshold income to £150,000 because that's £230,000 less £80,000. This means that annual allowance will be £60,000 for 2024/25, and so the taper won't apply. The payment of £80,000 is within her earnings for the tax year and will receive tax relief at marginal rate.

Next slide please.
Here's Brian. Brian's a partner in an accountancy firm and he'll be earning £110,000 in a 2024/25 tax year. He's been making occasional single contributions into a personal pension plan since September 2020. He's already contributed £25,000 in 24/25.

He's never been a member of any other pension schemes and now wants to make a substantial further single contribution before the end of the 24/25 tax year.
Brian 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.

Next slide please.
OK, so we've got Brian now in his table  - looks like this.
A total of £45,000 unused annual allowance was available in 22/23 being carried forward from ry 20/21 and 2021/22.
The £20,000 excess over the annual allowance that was paid in 2022/23 is covered by the £20,000 carry forward from 2000/21, so a £25,000 carry forward from 2021/22 is still available to be used in 2024/25.
The £20,000 carry forward from 2020/21 is shown in teal to indicate that it's not available for use in 24/25.
So after paying the single contribution of £25,000 in tax year 2024/25, a further member contribution of up to £80,000, that's £25,000 plus £20,000 plus £35,000. That could be paid before the end of the tax year without an annual allowance charge applying.
This total contribution is within Brian's earnings, so will be eligible for tax relief.
If Brian had had carry forward from 2019/20 that could have been used to partially or completely offset the excess in 2022/23. That would mean that more carry forward would be available in 24/25.
If it completely offset the excess, that would have meant another £20,000 of carry forward could be used in 2024/25, giving a further £100,000 that could be paid without an annual allowance charge applying. This is less than his earnings and so would be eligible for tax relief.

 

Next slide please.
OK. To summarise, we've gone over a fair bit of ground here. The concepts 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 tax years.
The main points are that tax relief on member contributions and pension input periods operate over the tax year.
It's possible to pay a contribution that gets tax relief, but which also attracts an annual allowance charge.
Carry forward can boost the annual allowance available.
Any annual allowance charges 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.

High earners can have a taper reduction in their annual allowance
And that's it. I hope you found this presentation useful. I know a better understanding of how tax refund the annual allowance interact. A copy of this presentation can be found in the CPD and webinar sections of Technical Central.

OK. And just to reiterate the learning objectives -  hopefully the learning outcomes have been they have an understanding of:

• the rules of tax relief and how much is available
• relationship between 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?

Thank you for listening.