One of the ways the UK government encourages us to save for our own retirement is by providing tax incentives to registered pension schemes. These rules allow tax relief on contributions paid by you or your employer, favourable tax treatment of growth in the pension fund, and the availability of a tax-free lump sum on retirement. A system of allowances restricts the availability of these tax incentives; in this guide, our Financial Planners here at Vesta Wealth explain how the UK’s pension allowances work and what you can do to navigate them wisely. We hope you find this useful and invite you to contact us if you would like to discuss your own retirement strategy.
The annual allowance
The annual allowance limits the amount of tax relief available for contributions paid to your pension each year. It takes into account all contributions paid by you or on your behalf, such as by your employer, and any tax relief on those funds. The main points to note are:
- The standard annual allowance is £40,000 in 2021-22. If you are making a personal contribution, this will be restricted to the annual allowance or 100% of your earnings (whichever is lower). For instance, if your salary is £30,000 it means you can contribute up to this amount into your pension; if you exceed this limit, you will suffer a tax penalty on the excess, at your marginal rate of income tax.
- There is an option to carry forward any unused annual allowance from the previous three tax years into the present one, provided you were a member of a UK registered pension scheme in those tax years. If you are making a personal contribution, you must also earn at least the amount you wish to contribute. So, if you want to contribute a total of £100,000 to your pension in 2021-22, then this must be no more than your total earnings for that tax year.
- If you have very high earnings (threshold income above £200,000 and adjusted net income above £240,000), your standard annual allowance may be reduced by tapering, at the rate of £1 for each £2 of earnings above the adjusted net income threshold, to as low as £4,000 if your adjusted net income is £312,000 or above.
- Beware of the Money Purchase Annual Allowance (MPAA) rules, when these are triggered, your annual allowance is reduced substantially from up to £40,000 per tax year, down to £4,000. Once you have triggered the MPAA, you will lose the ability to utilise carry forward allowances. A range of events can trigger the MPAA, including taking any income under the flexi-access drawdown rules. As such, be careful to consider financial advice if you want to make a pension withdrawal. There are some exceptions that you may be able to make use of, which do not trigger the MPAA rules. e.g. you can normally fully withdraw three pension pots under £10,000, if they are paid under the small pots rules.
- For those with earnings up to £3,600, the amount of contribution which can benefit from tax relief is £3,600. Depending on the type of pension scheme, you may be able to make a pension contribution which qualifies for tax relief, meaning you pay £2,880 and the government adds £720 tax relief, even if you have no earnings at all.
- Note that no tax relief applies to personal contributions, after you have reached age 75.
- For those in defined benefit pension schemes, the rules are more complex and depend on the increase in the value of your annual pension (the accrual rate) during the year, after allowing for inflation. Your pension scheme administrator should be able to provide information about that.
The lifetime allowance
This limits the value of tax advantaged benefits you can receive from your pension; in 2021-22 the lifetime allowance is £1,073,100. After you have exceeded this amount, you are likely to pay a lifetime allowance tax charge of 25% on the excess (55% if taken as a lump sum).
It is not always easy to tell if you will exceed the lifetime allowance. If you have a personal pension, such as a SIPP, which is currently under the limit, growth could take you over the allowance in the future. If your employer has a defined benefit pension which will pay you a guaranteed lifetime income from when you retire, to get an idea of its value, you need to multiply your expected annual income from the scheme by 20; then, add the amount of any lump sum you may receive. For example, if you expect to receive £10,000 per year from the scheme and also a lump sum of £20,000. This could equate to a pension value of £220,000.
Note that the lifetime allowance is tested each time you start to take benefits from your pensions, and again at age 75 if you have a money purchase pension.
Note that you may have a higher (or lower) lifetime allowance, depending on whether you hold a valid lifetime allowance protection certificate from HMRC. If you have a valid lifetime allowance protection certificate, in some instances this could be invalidated by making pension contributions or joining a new employer’s scheme, so it is essential that you speak to your Financial Planner before considering this.
Tips to navigate the rules
One of the key considerations when navigating these complex rules is mitigating unnecessary tax. This can be difficult, as tax rules change and by their very nature, pensions tend to be part of a long-term plan, so you should discuss these issues regularly with your Financial Planner.
If you are considering making contributions to your pension, ensure you have correctly calculated the available allowances in plenty of time, and beware of falling into traps of the MPAA, tapering and the potential risk to losing any form of lifetime allowance protection.
For the lifetime allowance, planning ahead as early as possible can help mitigate this, although many people do say that this is a nice problem to have. Bear in mind that the lifetime allowance has changed several times under successive, past governments and is currently significantly lower than when it was introduced in 2006 and therefore affects many more people than was perhaps originally intended. One way to protect yourself is to make use of other tax-efficient saving/investment vehicles alongside your pension to help cover your retirement expenses, such as ISAs, after consulting your Financial Planner.
Invitation
If you would like to discuss your financial plan and retirement strategy, then we would love to hear from you. Get in touch with your Financial Planner here at Vesta Wealth in Cumbria, Teesside and across the North of England.
Reach us via:
t: 01228 210 137
This content is for information purposes only. It should not be taken as financial or investment advice. To receive personalised, regulated financial advice regarding your affairs please consult your Financial Planner here at Vesta Wealth in Cumbria, Teesside and across the North of England.