- Financial planning
- 5 minute read
Saving into a pension is one of the most tax-efficient ways to save for retirement. Not only do pensions enable you to grow your retirement savings largely free of tax, but they also provide tax relief on contributions. However, there are various pension allowances in place that you need to be aware of. These limit the amount of money you can contribute to a pension in a year, as well as the total amount of money you can build up in your pension accounts, while still enjoying the full tax benefits.
In this guide, we look at the different pension allowances that exist, including the Annual Allowance, the Tapered Annual Allowance, the Money Purchase Annual Allowance, and the Lifetime Allowance, and highlight a few strategies that could help you manage your pension allowances more effectively.
What is the pension Annual Allowance?
The pension Annual Allowance is the maximum amount of money you can pay into a defined contribution pension scheme in a single tax year and receive tax relief on. All contributions made to your pension by you, your employer, or any third party, as well as any tax relief received, count towards your Annual Allowance.
Tax relief can be thought of as a reward from the government for saving for retirement. When you receive tax relief on your pension contributions, some of your money that would have gone to the government as tax goes towards your pension instead.
Tax relief is paid on your pension contributions at the highest rate of income tax you pay. Basic-rate taxpayers receive 20% tax relief, meaning an £800 pension contribution is topped up to £1,000, while higher-rate taxpayers and additional-rate taxpayers can claim 40% and 45% tax relief respectively through their tax returns. Note that in Scotland, income tax rates are different, so tax relief is applied in a slightly different way.
How much is the pension Annual Allowance?
The standard pension Annual Allowance is currently £40,000 or 100% of your income if you earn less than £40,000.
So, for example, if you earn £90,000 and want to contribute £45,000 to your pension this tax year, you’ll only receive tax relief on £40,000. Similarly, if you earn £25,000 and want to contribute £30,000 to your pension this tax year, you’ll only receive tax relief on £25,000.
A lower Annual Allowance may apply, however, if you are a high earner, or you have already started accessing your pension. High earners potentially face the Tapered Annual Allowance (TAA), while those who have already started accessing their pension potentially face the Money Purchase Annual Allowance (MPAA). We explain these pension allowances below.
What is the Tapered Annual Allowance (TAA)?
For higher earners, the Annual Allowance is tapered. The way the Tapered Annual Allowance works is that anyone with a ‘threshold income’ of more than £200,000 and an ‘adjusted income’ of more than £240,000 has their Annual Allowance reduced by £1 for every £2 that their adjusted income is over £240,000. Threshold income refers to all income excluding pension contributions. Adjusted income refers to all your income including pension contributions. You can find out more about how to calculate your threshold income and your adjusted income here.
The maximum Tapered Annual Allowance reduction is £36,000 meaning that if your adjusted income is more than £312,000, you will still have an Annual Allowance of £4,000. The table below shows the TAA at various adjusted income levels.
Tapered annual allowance
What is the Money Purchase Annual Allowance (MPAA)?
If you have started to withdraw money from your defined contribution pension, you may face a lower Annual Allowance. This is known as the Money Purchase Annual Allowance. For the 2020-21 tax year, the Money Purchase Annual Allowance is £4,000.
Whether the MPAA applies will depend on how you have accessed your pension.
Situations that trigger the MPAA include:
- Taking your entire pension as a lump sum or starting to take ad-hoc lump sums from your pension
- Putting your pension into a flexi-access drawdown scheme and taking income
- Buying an investment-linked or flexible annuity where your income could decrease
Situations that don’t normally trigger the MPAA include:
- Taking a tax-free cash lump sum and buying a lifetime annuity that provides a guaranteed income for life that stays level or increases
- Taking a tax-free cash lump sum and moving your pension into a flexi-access drawdown scheme but not taking any income from it
The rules around the MPAA can be quite complex so it’s worth speaking to a financial adviser if you are unsure about how this pension allowance works.
What happens if you exceed the Annual Allowance?
If you exceed the Annual Allowance in a year, you face an Annual Allowance Charge (AAC). This will be added to your taxable income for the year.
How does pension carry forward work?
Pension carry forward rules enable you to carry forward any unused Annual Allowances from the previous three tax years. This means that if you have unused Annual Allowances you can potentially pay in more than your £40,000 Annual Allowance and still receive tax relief.
To use carry forward, there are two main requirements you need to meet:
- You need to have had a UK-registered pension scheme in each tax year you wish to carry forward from. Note that you do not have to have made any contributions into this pension and the new contribution does not have to be into the same pension.
- You need to have earnings in the current tax year of at least the total amount you are looking to contribute into your pension. So, for example, if you are looking to contribute £70,000 into your pension this year, you must have an income of at least £70,000.
You can find more information in relation to pension carry forward rules here.
What is the Lifetime Allowance (LTA)?
The Lifetime Allowance is the total amount of money that you can build up in your pension accounts while still enjoying the full tax benefits. If you go over the LTA, you will pay a tax charge on the excess whenever you take income or withdraw a lump sum from your pension, or reach the age of 75 without having taken any benefits.
When the Lifetime Allowance was introduced in the 2006/2007 tax year, the threshold was £1,500,000 and increased to £1,800,000 by 2010/2011. However, since then, the LTA has been reduced significantly although it has been increased in line with CPI inflation in recent years.
For the 2020-21 tax year, the LTA is £1,073,100. This means that if the value of all your pensions exceeds this amount, you will have to pay Lifetime Allowance tax charge on the excess.
There are a number of scenarios that trigger a LTA tax charge, including taking money out of your pension, transferring your pension overseas, or turning 75 without having taken any benefits from your pensions.
You can find more information on the Lifetime Allowance and how to plan ahead for it here.
Pension planning: capitalising on the tax relief available
There are a number of strategies that can help you make the most of your pension allowances. These include:
- Claiming your tax relief: the tax relief offered on pension contributions is very generous so it makes sense to contribute as much as you can to your pension in order to take advantage of the tax relief on offer. If you’re a higher-rate or additional-rate taxpayer, make sure you claim your extra entitlement through your tax return. Every year, many higher earners forget to do this which means that millions in tax relief is unclaimed.
- Making contributions on behalf of your spouse: if you’ve already maxed out your own Annual Allowance, consider making contributions on behalf of your spouse. If your spouse is working, you can make contributions on their behalf of up to £40,000, or 100% of their salary each year, whichever is lower. And if your spouse is a non-taxpayer, you can still make pension contributions for them up to £2,880 per year, which will be grossed up to £3,600.
- Making use of pension carry forward rules: you can carry forward any unused Annual Allowance from the previous three tax years, even if you face a Tapered Annual Allowance. Using pension carry forward rules could allow you to pay in more than your £40,000 Annual Allowance and still receive tax relief.
- Making contributions from your limited company: if you work through your own limited company, consider making employer contributions through your company. These are treated as a business expense, which means that they can be offset against your corporation tax bill.
Pension allowances: the rules can be complex
While pensions offer a tax-efficient way of saving for retirement, the rules around pension allowances are complex.
If you are unsure about how the various pension allowances work, it’s a good idea to speak to a financial adviser. An adviser will be able to guide you through the complexity and ensure you make the most of your allowances.
To find out more or if you have any questions about pensions allowances, don’t hesitate to request a call back.
Capital at risk. Please note that any tax benefits will depend on your personal tax position and rules are subject to change. In some instances, rules can vary between different regions of the UK and we recommend speaking to a financial adviser for your regional rules.