The 2020 Budget on 11 March feels like a lifetime ago in many respects, but the changes announced by the government to the pensions Annual Allowance and the Lifetime Allowance came into effect on 6 April and will be beneficial to many. This article provides a back to basics look at how those changes may apply to someone currently saving into a pension scheme.
The Annual Allowance
Ordinarily contributions to a pension scheme can be paid from your salary into a pension scheme without you first having to pay income tax on that part of your salary. The Annual Allowance ('AA') is the maximum amount of pension saving you can make in each tax year before you have to start paying income tax on the amount contributed. The AA applies across all of your pension arrangements and includes contributions made by your employer.
The standard AA is currently £40,000. However, high earners are subject to a lower amount, known as the tapered Annual Allowance. You may recall the headlines of early 2020 around senior NHS doctors retiring early or refusing to take on the extra shifts upon which the NHS depends. The reason for this was the impact of the taper of the AA from £40,000 down to £10,000, and the very complex way the calculations work, resulting in unexpected tax charges for doctors.
In order to address this issue, the government has increased by £90,000 the amount of income a person can receive each year before the taper to the AA starts to apply. As of 6 April, anyone whose income exceeds £200,000 and whose income and pension contributions combined equal more than £240,000 will be subject to a reduced AA of £1 for every £2 over £240,000. The AA tapers down to a minimum AA of £4,000 for anyone receiving total income and pension contributions of £312,000 or more each year.
In practice this means that if your income is more than £110,000 per year you may now be able to contribute more into your pension scheme in 2020/21 before you start to pay income tax on contributions than you have been able to in recent years. Given how very tax efficient pension savings are, it is generally financially desirable to contribute the most you can in each tax year to your pension scheme.
How contributions are calculated for the Annual Allowance
If you are a member of a defined contribution pension scheme (i.e. a scheme in which your ultimate benefits depend upon how much you have contributed and the return on those investments), your annual contributions for AA purposes are simply the amount of money that has been paid into your pension scheme in that year.
The calculation is more complicated, however, if you are a member of a defined benefit pension scheme (i.e. a scheme which provides a pension on retirement calculated by reference to your salary when you leave employment and the length of your employment). In this situation, annual contributions for AA purposes are calculated (in very broad summary) by establishing the difference between the annual pension you were due to receive at the start of the tax year and the annual pension you are due to receive at the end of the tax year. The growth in your annual pension is then multiplied by 16 to arrive at a figure to compare against the AA.
Contributions above the Annual Allowance
The AA is not a cap on the amount of contributions that you can make to a pension scheme. It is simply a limit on the tax relief available on those contributions. Pension savings are very tax efficient, and so in some situations it may make financial sense to contribute above the AA.
It is also possible to use unused AA from up to three previous financial years, which may allow you to make contributions above the AA without having to pay income tax on that amount.
The Lifetime Allowance
The Lifetime Allowance (the 'LTA') is the maximum amount of pension savings you can build up across all of your pension arrangements during your lifetime before a tax charge is applied. On 6 April the LTA increased slightly to £1,073,100. If you have previously applied for LTA protection, you may have a higher personalised LTA.