It is worth shedding some light on some of these rules to make the fundamentals of contributing to a pension clearer. Furthermore, there are more complex positions which, most definitely, invite confusion.
Contribution basics
How much can I contribute? It is possible to contribute any amount with no maximum limits. However, you need to consider the amounts where tax relief can be obtained. While most savers will remain within these boundaries, there can be circumstances where contributing above the limits is appropriate.
What are the tax relief limits? Anyone up to age 75 can contribute £3,600 gross of basic rate tax relief per annum, regardless of their income (or lack of income) and qualify for tax relief on contributions. For those earning over £3,600, contributions up to 100% of UK relevant earnings can receive income tax relief up to a maximum of £40,000 – this is known as the ‘annual allowance’. Contributions greater than the annual allowance may be possible, if unused allowance from the three tax years preceding the current one can be carried forward.
Individuals should be aware that, when accessing taxable benefits flexibly from a pension fund, for example via flexi-access drawdown, the allowance is reduced to what is known as the ‘money purchase annual allowance’ (MPAA) of £4,000.
Relevant earnings? Yes, not all income is equal! UK relevant earnings only considers income from sources such as employment, self-employment or patent income (plus some other rarer cases). Notable sources of income not counted are capital gains and pension, dividend, property or investment income.
What about after age 75? There is no tax relief on contributions made after age 75.
So now we understand how much can be contributed, we must now consider the how.
How do I contribute? An individual, an employer or a third party can contribute. Extra care is needed for sole traders and partnerships that pay from the business account to ensure that the contribution is treated as a personal contribution, and that the tax relief is given.
Personal contributions. Personal contributions via the more common ‘relief at source’ method are treated as amounts paid after deduction of basic rate income tax. The ‘net’ contribution is paid to the pension scheme and the pension provider will recover relief at the basic rate of tax from HM Revenue & Customs (HMRC) on your behalf and add it to the pension. For higher or additional rate taxpayers, the additional entitlement to tax relief over and above basic rate needs to be reclaimed by the individual through self-assessment.
Employer Contributions. These are typically paid gross, by your employer. An employer contribution is not measured against the individual’s tax-relievable amount (relevant earnings) and the overriding limit remains the annual allowance. That said, payments made by an employer on behalf of an employee must be justifiable for the role, as per the ‘wholly and exclusively’ rules, in order for the employer to obtain corporation tax relief.
Third-party contribution. This is where someone other than the individual or employer makes contributions into a pension scheme on the individual’s behalf. An example of this may be grandparents contributing for their grandchildren. This means starting contributions before they have perhaps started working, or even before they start school! It is important to note that third-party contributions are assessed on the recipient’s ability to contribute rather than the person making the payment.
For an employee there are some alternative ways to make personal contributions to their work-based scheme.
Net pay. Where contributions are made from salary before income tax is deducted, meaning there is no further action required to obtain any tax relief above the basic rate. National Insurance Contributions (NICs) are still payable. This is most often seen in occupational pensions.
Salary sacrifice. The employee contractually agrees to sacrifice a specified level of salary to be replaced by pension contributions of the same value to be made by the employer. There are no NICs to pay on the salary that has been given up (either by the employee, who often has an increased take home pay as a result, or the employer) and in this case the contributions are considered employer contributions.
Be careful… Where an individual’s annual allowance and any available unused allowance to be carried forward is breached, a tax charge is applied. Essentially, the amount you have exceeded the annual allowance by will be added to any other taxable income in the tax year and be subject to income tax at the rate(s) that apply to you. You may have the option of paying the charge through pension benefits in what is known as scheme pays. This simply corrects the position of tax relief on contributions over the annual allowance.
While the above information covers most queries, there are always going to be exceptions that come with additional rules, particularly in the world of pensions.
Contribution complexities
Is the annual allowance is fixed? No! It is not for high earners anyway. In the current tax year, those with taxable adjusted income over £240,0000 have their allowance reduced to a tapered annual allowance.
The tapered annual allowance means that for every £2 of income over £240,000, the annual allowance is reduced by £1, down to a minimum of £4,000. It is important to note that those with a threshold income of less than £200,000 are not affected by the taper.
What is the difference between adjusted income and threshold income? Put simply, adjusted income includes your total taxable income and any employer contributions, while threshold income is generally your total taxable income less all personal relief at source pension contributions (with any pension sacrifices added on if a new arrangement after July 2015).
What if the annual allowance has not been used in earlier years? Then carry forward allows unused annual allowance from the three previous tax years to be carried forward and added to the annual allowance for the current tax year. It is only possible to use carry forward after the current year’s allowance has been fully used up and unused allowance starts with the earliest year first.
The criteria are that the scheme member must have been a member of a registered UK pension for the years that the carry forward is being considered and that relevant UK earnings in the current tax year are at least the total amount to be contributed, if a personal contribution is being considered. This works for those who have high earnings one year and want to utilise the annual allowance from previous years (this could either be because they did not fully use their allowance or did not have sufficient earnings to maximise contributions in those earlier years), or can make significant employer contributions. You still must be mindful of very high earners as tapering can apply.
Navigating the rules
It is always helpful to see these rules in action so let’s take a look at Victoria’s contribution conundrum.
Victoria starts the tax year with a total annual salary of £210,000 (and no taxable income from other sources) where her employer pays a 10% pension contribution. Victoria has not been making any personal contributions to her pension.
We need to consider both the threshold and adjusted income to check whether the annual allowance will be tapered. For Victoria, her threshold income is £210,000 whereas her adjusted income includes £21,000 employer contributions, so will total £231,000. The adjusted income sits under the £240,000 limit so the annual allowance of £40,000 is not reduced.
However, towards the end of the tax year, Victoria receives a bonus of £20,000. Now we revisit the threshold and adjusted income which are £230,000 and £251,000 respectively. With the adjusted income over £240,000 by £11,000, Victoria’s annual allowance is reduced by £1 for every £2 over the adjusted income – in this case £5,500. Leaving Victoria with a tapered annual allowance of £34,500.
At this stage, this is not an issue for Victoria as the pension contributions of £21,000 are under the reduced annual allowance.
However, Victoria would like to use the bonus payment to contribute to her pension scheme.
If she elected to sacrifice the whole bonus it would form a further employer contribution and would exceed the limit, as employer contributions are included when considering adjusted income. With contributions totalling £41,000, a tax charge would apply on the £6,500 excess, unless she had sufficient unused allowance from a previous tax year to offset this.
However, if she sacrificed just £13,500 of the bonus and received the remainder (£6,500) in her salary, her adjusted income would remain £251,000 but she would not exceed her tapered allowance of £34,500 (the £21,000 employer contribution and the £13,500 bonus sacrifice).
Finally, if she paid the contribution personally as her adjusted income would remain £251,000 and her threshold income would not fall below £200,000 with the £20,000 contribution, she would either have to rely on carrying forward unused allowance or, if unavailable, would have a tax charge on the excess £6,500.
Careful Planning
The case study shows that consideration of income levels and the use of carry forward can ensure the most tax efficient way to make contributions.
The basic advice is right; saving for retirement from an early stage makes saving for retirement a gradual process rather than a last-minute panic. The first step is the most important by establishing a pension scheme and paying in the first contribution. Over time, planning evolves to fit in with income levels and retirement aspirations. At first, the basic advice might be sufficient but certainly, as careers progress and retirement planning is more focused, seeking good financial planning advice will help keep those retirement plans in check. Ensuring they are achievable through identifying the various limits, potential tapering and ultimately the best options available.
* Please note the above pension contribution allowances are based on the 2022/23 tax year rules and can change in future years.
