How much is too much?: The Annual Allowance & Pension Contributions
Whilst you may be entitled to a State Pension once you reach retirement age, you may wish to have additional funds in order to support you.
Pension funds aim to provide you with a further source of income to draw on later in life and are oftentimes a tax-efficient way to save for your retirement. This is because not only can you receive tax relief on payments made into your pension, but growth within the pension is also tax free.
With this in mind, please read on for our summary of the taxation of pension contribution.
Maximum Contribution & “Relevant Earnings”
Firstly, the maximum contributions you can personally make into your pension in a year is the greater of £3,600 and 100% of your “relevant earnings”.
Relevant earnings include all types of employment income (e.g. salary, benefits, taxable termination payments), trading income, and profits from furnished holiday lettings.
Income arising from interest, dividends, and rental profits do not count as relevant earnings for these purposes.
It is important to note that this limit does not apply to contributions made by an employer, therefore this may be the preferable route for director-shareholders who pay themselves a small salary and dividends.
The Annual Allowance
The maximum pension contributions a taxpayer can make into their registered pension scheme tax free is called an ‘annual allowance’.
The allowance is currently set at £40,000 (gross) for the 2018/19 tax year.
The allowance limit is not a ‘per scheme’ basis and the £40,000 limit is inclusive for all registered schemes the taxpayer belongs to.
Unlike the “relevant earnings” limit above, the annual allowance applies to contributions made into a scheme by both you and your employer.
The allowance can be increased by unused allowances for the previous three years or reduced if you are a high income individual.
Unused Annual Allowance
You can increase your annual allowance with unused annual allowances from the three previous tax years. When you make a contribution into your pension, the current year annual allowance must be utilised first, followed by the unused allowance from the earlier year.
The unused allowance can only be carried forward if the individual was a member of a registered pension scheme in that year – even if no contributions were made. Therefore, individuals who are not part of a registered pension scheme cannot carry forward that tax year’s unused annual allowance.
Tapered Annual Allowance
The annual allowance is reduced for high income individuals with a threshold income over £110,000 and adjusted income in excess of 150,000.
“Threshold income” is defined as net income (i.e. total income less deductible payments, such as interest on certain qualifying loans) less the amount of any gross pension contributions for which relief has been given at source.
“Adjusted income” is net income plus a) pension contributions made for which relief was received as a deduction in arriving at employment income (e.g. salary sacrifice), and b) contribution paid by the employer.
If you are a high income individual, the annual allowance will be reduced by £1 for every £2 in excess of the £150,000. The annual allowance cannot be reduced below £10,000.
What happens if you go above the annual allowance limit?
If you contribute more than your annual allowance in a tax year, any contributions above the limit will be charged to income tax.
The rate of tax charged on the excess pension contributed will depend on your marginal rate of tax, e.g. if you are a basic rate tax payer, the excess contributions will be charged at 20%, and if you are a higher rate taxpayer, then the excess will be charged at 40%.
The excess pension is charged at the rate that would apply if the excess contributions was the top slice of the taxable income, i.e after earned income, interest, and dividends.
If the charge exceeds £2,000, then you can elect for the charge to be paid from your registered pension scheme.
If you are looking to make contributions into your pension scheme and require advice as to the tax consequences, please contact a member of our team.