Annual allowance: is paying a tax charge such a bad thing?
The reduction in annual allowance and tapered annual allowance has seen a rise in individuals facing an annual allowance tax charge. When this happens, the natural instinct is to avoid the charge – even if this means leaving the scheme. But is this the right thing to do? Let’s see.
- Annual allowance is based on pension input periods.
- Pension input periods are aligned with tax years.
- Annual allowance is currently £40,000.
- Any contributions over the annual allowance available attract a tax charge.
- A reduced annual allowance could apply if the money purchase annual allowance or tapered annual allowance has been triggered.
What is the annual allowance? A reminder.
The annual allowance is the maximum amount of pension savings an individual can make each year with the benefit of tax relief. This includes pension contributions made by the individual, their employer, or a 3rd party. It’s currently £40,000 and you can find out more on our annual allowance page.
Where the current year’s annual allowance has been exhausted, it may be possible to reduce or completely avoid the annual allowance charge using carry forward.
If, having exhausted all available carry forward and the annual allowance is exceeded, the individual will be liable to pay a tax charge. It’s up to the individual to account to HMRC for the charge through completion of a self-assessment tax return. In certain circumstances, they can ask their pension scheme to pay the charge on their behalf. The pension scheme is only obliged to facilitate the payment of the charge if certain conditions apply. We tell you these in our Scheme pays article.
Should I stay or should I go?
What was once famously asked by Mick Jones of The Clash can also apply to those thinking of leaving their scheme to avoid a tax charge. Will the individual derive greater benefit from opting out and thereby avoid future charges or greater benefit from remaining in the scheme and paying the charges? The value of employer contributions should not be overlooked.
Let’s look how this can happen in practice.
Jennifer, lives in England and is a company director with a salary of £300,000. She’s a 45% taxpayer, subject to a tapered allowance of £10,000 and has no carry forward available. Her employer pays 8% as standard and contributions are matched 1 for 1 up to a further 6%. Jennifer expects to retire in 10 years’ time.
|Employer contributions only (8%)||Employer + employee contribution (14% + 6%)|
|Pension input amount||£24,000||£60,000|
|Annual allowance excess||£14,000||£50,000|
|Annual allowance charge||£6,300||£22,500|
|Post charge benefit||£17,700||£37,500|
|Value of additional funds in 10 years1||£26,200||£55,500|
|Net cost to Jennifer||£0||£9,900|
1Assumes 4% growth after charges.
As you can see from the table under option 1, after paying the annual allowance charge, Jennifer will generate additional funds of £17,700 at no cost to herself.
But, under option 2, if Jennifer continues to make personal contributions, she will generate additional funds of £37,500. After taking into account tax relief, this will only cost her £9,900.
On top of this, as the pension input amount is greater than £40,000 and tax charge exceeds £2,000, she is eligible to make a scheme pays election.
The information provided is based on our current understanding of the relevant legislation and regulations and may be subject to alteration as a result of changes in legislation or practice. Also it may not reflect the options available under a specific product which may not be as wide as legislations and regulations allow.
All references to taxation are based on our understanding of current taxation law and practice and may be affected by future changes in legislation and the individual circumstances of the investor.