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.
Within this allowance, tax relief on an individual’s gross contributions is restricted to the higher of £3,600 or 100% of relevant UK earnings, that is the earnings that attract tax relief.
Individuals are subject to a tax charge on the amount of any contribution paid (personally, by the employer or a 3rd party) in excess of the annual allowance each year. The tax charge will be at the individual's marginal rate of tax. This also applies to the value of any benefit increase under a defined benefit or cash balance scheme over the annual allowance. If an annual allowance charge is due this will usually be dealt with through the individual's tax return.
The annual allowance has changed several times since it was introduced in 2006 and is £40,000 currently. Historic levels of the annual allowance can be found on our rates and factors page.
The following details how these benefits are valued when testing against the annual allowance:
The total contributions paid in any pension input period.
This includes all individual, employer and third party contributions
PTM053200: pension input amounts: money purchase arrangements
The increase in the value of the member's rights over the pension input period.
When working out how much the benefits have increased by, increase the value of the plan at the beginning of the pension input period by the increase in CPI over the 12 month period to the September before the start of the tax year in which the annual allowance is being calculated. This is then compared with the value at the end of the period.
The rights to be valued will include partial benefits taken during the period, any rights transferred out to another registered pension scheme, and any pension debits. The value of any rights given on transfers in to the scheme and any pension credits can be excluded.
The increase in value of the individual's rights during the pension input period.
When working out how much the benefits have increased by, calculate the annual pension amount at the beginning of the pension input period (this is the pension that the individual would get if they retired now at normal pension age). Then multiply this amount by 16. If the scheme also gives the individual a lump sum in addition to the pension (i.e. not by commutation of pension), add this on. The total should then be increased by the increase in CPI over the 12 month period to the September before the start of the tax year in which the annual allowance is being calculated.
Then calculate the value at the end of the pension input period; the end value shouldn't be increased by CPI. Multiply this amount by 16. Again, if the scheme also gives the individual a lump sum in addition to the pension (not by commutation of pension), add this on.
Deduct the start value you from the end you have calculated above, this is the pension input amount.
The rights to be valued will include any benefits taken during the period, any rights transferred out to another registered pension scheme, and any pension debits. The value of any rights given on transfers in to the scheme and any pension credits can be excluded.
More information on pension input periods and pension input amounts can be found in our article of the same name.
Everyone has a total annual allowance of £80,000 for pension input periods (PIPs) ending in 2015/16. Savings for PIPs ending in 2015/16 will be split into two mini tax years. Individuals have an annual allowance of £80,000 for all PIPs ending between 6 April 2015 and 8 July 2015.
Savings from 9 July 2015 to 5 April 2016 have a nil annual allowance but up to £40,000 of any unused annual allowance from the period 6 April 2015 up to 8 July 2015 (pre-alignment tax year) is added to this. The total of all pension contributions made by, or on behalf of, the individual to all their pension plans for PIPs ending in the same tax year is tested against the annual allowance for that tax year.
This is easy to do for money purchase arrangements as it is based on the amount paid in the two periods. It’s slightly more complicated for cash balance and defined benefit schemes.
The start value is calculated as normal at the start of the PIP but the close value is calculated as at 5 April 2016. The difference is the pension input amount (PIA).
You then calculate the total length of the PIP (A). Which is then split between the pre and post alignment tax years (B and C). The post alignment period runs from 9 July 2015 to 5 April 2016 and is 272 days.
You then multiply the PIA by 272/A, which give you the PIA in the post alignment period. Deduct this from the total PIA to get the pre alignment PIA.
Marco is in a defined benefit scheme with a PIP that ran from 1 February to 31 January. His PIA for the PIP running from 1 February 2015 to 5 April 2016 (430 days, 2016 was a leap year) was £75,467. He is not caught by the MPAA or tapered annual allowance.
Marco will have an annual allowance charge on £7,737.27 in the post-alignment period unless he has any unused annual allowance to carry forward.
The objective of the annual allowance charge is to remove the tax relief given to any pension contributions over the annual allowance.
In simple terms the tax relief given is based on the tax that would have been paid if the pension contribution had been taken as income.
The steps for calculating the annual allowance charge and how to pay the annual allowance charge can be found in HMRC's Pensions Tax Manual.
It may be possible to reduce or completely avoid the annual allowance charge using carry forward. Carry forward allows unused annual allowance from PIPs ending in the previous three tax years to be carried forward and added to the annual allowance for the current PIP.
More details can be found in our carry forward article.
From 6 April 2015 there is a new annual allowance called the money purchase annual allowance (MPAA). This is normally triggered by taking income from
a flexi-access drawdown plan or taking an uncrystallised funds pension lump sum. However, other actions can trigger it.
If the MPAA has been triggered, only £4,000 can be paid to all defined contribution plans in any PIP before the annual allowance tax charge is applied.
If it is triggered part-way through a pension input period only the contributions made after the trigger are tested against the MPAA. However the total contributions/accrual in that tax year are also tested against the £40,000 annual allowance.
HMRC has issued a guidance note: Money purchase annual allowance: split pension input periods which provides more detail.
HMRC Pensions Tax Manual - PTM056500: money purchase annual allowance
From 6 April 2020 - Individuals who have taxable income for a tax year of greater than £240,000 will have their annual allowance for that tax year restricted. It will be reduced, so that for every £2 of income they have over £240,000, their annual allowance is reduced by £1. Any resulting reduced annual allowance is rounded down to the nearest whole pound.
The maximum reduction is £36,000, so anyone with income of £312,000 or more will have an annual allowance of £4,000. Individuals with high income caught by the restriction may therefore have to reduce the contributions paid by them and/or their employers or suffer an annual allowance charge.
From 6 April 2016 to 5 April 2020 - Individuals who had taxable income greater than £150,000 had their annual allowance restricted. It was reduced, so that for every £2 of income they had over £150,000, their annual allowance was reduced by £1. The maximum reduction was £30,000, so anyone with income of £210,000 or more had an annual allowance of £10,000.
Our article, tapering of annual allowance for high incomes, provides more detail.
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.