FOR ADVISERS ONLY

Member contributions - tax relief and annual allowance

An individual can pay as much as they like into a pension but unfortunately, there's a limit on the amount of tax relief that can be given.

Key facts

Tax relief is based on tax years.
Annual allowance is based on pension input periods. Pension input periods are aligned with tax years.
Tax relief is limited to contributions up to the higher of £3,600 per tax year or 100% of earnings.
Annual allowance is £40,000 unless the money purchase annual allowance or tapered annual allowance apply.
Member contributions are unrestricted although a tax charge applies on contributions above the annual allowance, money purchase annual allowance or tapered annual allowance.
Income from a pension is not relevant UK earnings.
Investment income, property rental income and dividends don't count as relevant UK earnings.
Three main methods in giving tax relief; relief at source, net pay arrangement, and relief on making a claim.
Any contributions over the annual allowance, money purchase annual allowance or tapered annual allowance available may attract a tax charge.

How much tax relief is given?

Tax relief is calculated in tax years. In any tax year, tax relief is only given on gross contributions of up to £3,600 or 100% of relevant UK earnings, whichever is the higher. Looking at two examples, an individual with no relevant UK earnings can get tax relief on a contribution of up to £3,600 whereas an individual with relevant UK earnings of £25,000 can receive tax relief on contributions up to £25,000.

What are relevant UK earnings?

In short this is:

employment income
self-employed income
income from patent rights
certain redundancy payments
earnings from overseas crown employment

This means that salary counts as relevant UK earnings. Investment income and dividends don't. This can have implications for controlling directors in deciding whether to make a pension contribution as a member or an employer contribution.

Redundancy payments

Only part of a redundancy payment counts as relevant UK earnings. A redundancy payment can be made up of the actual redundancy payment and other payments such as salary, payment in lieu of notice or holiday pay. Any part of a lump sum redundancy payment that comes from salary, payment in lieu of notice or holiday pay does count as relevant UK earnings. However, only the part of the actual redundancy payment over the tax-exempt threshold of £30,000 will be classed as employment income and therefore count as relevant UK earnings.

Let's look at an example where an individual receives a lump sum payment on redundancy that's made up as follows:

one month's salary - £2,500
one month's salary in lieu of notice - £2,500
holiday pay - £750
redundancy payment - £31,250
total - £37,000

The first three items all count as relevant UK earnings. In addition to that, £1,250 of the redundancy payment is also classed as relevant UK earnings.

How is tax relief given?

This depends on what type of pension scheme we're talking about. There are three main methods and these are shown in the following table:

Type of pension scheme:

personal pension (including Stakeholder)

How does the tax relief work?

pension contribution is made from individual's salary after deduction of income tax and National Insurance contributions
when a pension contribution is received by the provider, basic rate tax relief is normally added to the contribution
the scheme administrator then reclaims the tax relief from HMRC

What about higher and additional rate tax relief?

claimed through individual's self-assessment form or by writing to HMRC

Type of pension scheme:

occupational pension scheme

How does the tax relief work?

the employer deducts contributions from the member's salary before income tax but not National Insurance contributions
must be used for all contributing members

What about higher and additional rate tax relief?

given immediately

Type of pension scheme:

relief on making a claim

How does the tax relief work?

claimed through individual's self-assessment form
used when not possible to use RAS and net pay arrangement

What about higher and additional rate tax relief?

claimed through individual's self-assessment form

Further details of how higher rate tax relief is given can be found in Member contributions and higher rate tax relief.

HMRC Pensions Tax Manual - PTM044100: Contributions: tax relief for members

The annual allowance

The annual allowance is the total amount of contributions that can be paid into all pensions for an individual before a tax charge applies. This allowance applies to all member contributions, employer contributions and contributions for the individual paid by a third party, for example a grandparent.

It is the contributions paid during a period of time, called a pension input period, that are tested against the annual allowance. Pension input periods are aligned with tax years. More details of pension input periods can be found in Pension input periods and pension input amounts.

For pension input periods ending in the current tax year tax year the annual allowance is £40,000. There's a tax charge on any contributions paid over the annual allowance in each year. This is called the annual allowance charge and is calculated at the individual's marginal tax rate. Any potential tax charge is dealt with through the individual's self-assessment or by writing to HMRC.

To see if an annual allowance charge applies the total amount of contributions paid in the pension input period needs to be calculated.

It may be possible to use carry forward to reduce or remove the annual allowance charge.

It's important to remember that the annual allowance and tax relief work separately from one another. This means it's possible for some contributions to receive tax relief but for an annual allowance tax charge to also apply. Let's take a look at how this works in the current tax year:

Individual's relevant UK earnings - £60,000.
They work and are taxed in England.
Annual allowance - £40,000.
Individual receives tax relief on gross contributions up to £60,000.
Annual allowance charge on (£60,000 - £40,000) = £20,000.
Only part of the excess contribution lies in the amount of taxable income taxed at 40%. So, the amount of the charge will be:

£60,000 - £50,270 (£12,570¹ + £37,700) = £9,730 x 40% = £3,892

£50,270 - £40,000 = £10,270 x 20% = £2,054

£3,892 + £2,054 = £5,946

Although the tax bands and rates of income tax in Scotland are different from the rest of the UK the calculation is the same but applied to the different bands/rates. The rates and bands in Scotland are as follows:

2022/23 bands	Band name	Rates (%)
Over £12,570¹- £14,732	Starter rate	19
Over £14,732 - £25,688	Basic rate	20
Over £25,688 - £43,662	Intermediate rate	21
Over £43,663 - £150,000²	Higher rate	41
Above £150,000²	Top rate	46

¹ Assumes the individual is in receipt of the standard UK personal allowance.

² The personal allowance is reduced by £1 for every £2 earned over £100,000.

To avoid double taxation, only contributions that receive tax relief count towards the annual allowance. If an individual's UK relevant earnings are £70,000 and they make a gross contribution of £80,000 to their plan, they'll only receive tax relief on £70,000 and will face a tax charge of 40% on the amount above the annual allowance, which in this case is £30,000.

If the money purchase annual allowance or tapered annual allowance applies the tax charge will be even higher.

Some frequently asked questions

Q. Does this mean everyone can get tax relief on contributions up to £40,000?

A. No, to get tax relief the total gross member contributions still have to be within the higher of 100% of relevant UK earnings in the tax year and £3,600 p.a. What the annual allowance, MPAA or tapered annual allowance does is place a limit on the amount of tax relief a member can receive.

For defined contribution schemes, the pension input amount is simply the total of all gross contributions. If the pension input amount exceeds the annual allowance, MPAA or tapered annual allowance, an annual allowance charge is payable on the excess via the member's Self Assessment.

So if Sally has UK earnings of £60,000 and tax relief is given by the relief at source method, she can pay a net contribution of up to £48,000. The provider will gross this up to £60,000 and claim the £12,000 basic rate tax relief from HMRC. Sally will then claim higher rate tax relief through her Self Assessment but will also have to declare that her pension input amount is £20,000 over the annual allowance. A tax charge equal to her marginal rate of tax will be levied, effectively removing all tax relief from the excess contributions. If the MPAA or tapered annual allowance applied to her the tax charge would be levied on the difference between £60,000 and the lower annual allowance that applies.

Q. How does this work with employer contributions?

A. If they meet the 'wholly and exclusively' conditions the employer can claim corporate tax relief in respect of them. Employer contributions count towards the annual allowance, MPAA or tapered annual allowance and if that results in contributions of over £40,000 being paid in respect of a member an annual allowance charge will be payable by the member.

Q. Does the annual allowance operate over the tax year?

A. Yes, since 8 July 2015 the pension input periods have been aligned to the tax year for all plans.

Q. If a member hasn't paid the maximum tax relievable contribution in previous tax years can they use carry forward to pay contributions higher than 100% of earnings in this tax year?

A. No, it's unused annual allowance that's being carried forward, not unused tax relief. If Sally in the example above had unused annual allowance of at least £20,000 to carry forward, she could avoid the annual allowance charge. However if she had paid less than 100% of her earnings in previous years, that unused tax relief couldn't be carried forward to justify tax relief on member contributions of more than £60,000.

You cannot use carry forward to pay a contribution to a money purchase plan if the MPAA applies.

Q. How much can a controlling director pay into a registered pension in a tax year?

A. Since 6 April 2006 contributions paid by and in respect of controlling directors are subject to the same limits and restrictions as anyone else.

HMRC Pensions Tax Manual - PTM043200: Contributions in respect of members who are directors who are shareholders or connected to a controlling director

Further information

Note

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.

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