How will the annual pension allowance be tapered for high earners from 2016?

Monday 14 March, 2016

The Government have made a number of pension changes during the last year. One of the areas that has changed is the annual pension allowance for high earners. From 6th April 2016 there will be a cut in the amount of tax-efficient pension saving for some high income earners. Two tests determine if this cut applies to you.

Test 1 – Adjusted Income Test

The standard £40,000 annual allowance (AA) will be reduced by £1 for every £2 of ‘income' individuals have over £150,000 in a tax year, until their allowance drops to £10,000. If you had an income of £210,000 your AA will be cut by £30,000. The test uses ‘adjusted income' in the tax year, broadly consisting of:

• an individual's income from all sources before tax (ignoring pension contributions), and
• the value of any employer pension contributions.

Example 1 – Employer contribution triggers Annual Allowance cut

If Steve has total income of £140,000 and his employer pays £30,000 into his SIPP during the 2016/17 tax year his adjusted income for the tax year is £170,000. As this is £20,000 over the £150,000 cap it will reduce his AA by £10,000. So for 2016/17 his AA will be cut from £40,000 to £30,000.

Defined Benefit Schemes - For a defined benefit (DB) scheme, it's the total pension input, less individual contributions paid to the scheme. Affected DB earners will have to make a choice either - remain in the existing scheme and suffer the tax charge; or leave the DB scheme and consider funding up to the reduced AA in a money purchase scheme. They should consider how much employer funding could be lost by leaving the DB scheme.

Test 2 – Threshold Income

Not everyone failing the ‘adjusted income' test will see their Annual Allowance cut. For individuals with pension saving > £40,000 AA in the tax year, even if their adjusted income exceeds £150,000, their annual allowance won't be cut if their ‘threshold income' is £110,000 or less for the tax year.

'Threshold income' uses the same starting point of total income before tax, after individual pension contributions are deducted, and normally employer contributions are not added. However be aware that:

• Any employer contributions from new salary sacrifice arrangements started after 8/7/15 are added;
• Anti-avoidance legislation will be introduced to ignore arrangements designed to shift income earned in one tax year, but taxed in a different year.

Other ways pension contributions reduce threshold income

Business owners control what the company does with its profits. Making an employer pension contribution into their own pension is not ‘salary sacrifice,’ as the business owner has not given up salary in exchange for a pension contribution, but paid themselves a pension contribution from company pre-tax profits.

Example 2 – Employer contribution doesn't affect Annual Allowance

Katrina’s runs her own business and has income of £100,000 for the 2016/17 tax year. If she makes an £80,000 employer pension contribution into her SIPP by using carry-forward of unused AA from previous tax years her ‘adjusted income' (her ‘real' income plus employer pension contribution) is £180,000. As this is £30,000 above the £150,000 cap, it would normally cut her AA by £15,000 (to £25,000). However, as her threshold income of £100,000 is below the £110,000 limit, Katrina keeps her full £40,000 AA.

Some employees can also reduce their ‘threshold income' by making a pension contribution. Where someone has employer pension contributions taking them over the adjusted income threshold they can make a personal contribution to bring their threshold income below £110k.

Example 3 - personal contributions restore full Annual Allowance

Anil earns £120,000 in tax year 2016/17, his other taxable income is £2,000. He is a member of his employer's occupational workplace pension, contributing 15% (£18,000) which his employer tops up on a 2 for 1 basis (£36,000).  Anil's adjusted income for the year is £158k, so he thinks his AA will be cut......

To calculate his 'threshold income', Anil must deduct his £18,000 pension contribution from his £122,000 income, = £104,000 threshold income.  He can keep his £40,000 AA (as it's below the £110,000 limit).

The reduced allowance and carry forward

It will still be possible to carry forward unused allowances to use in a tax year where the standard Annual Allowance has been reduced. But the available carry forward from a tax year where the annual allowance has been reduced by the taper will be the balance of the tapered amount.

How to maximise pension funding - 2015/16

This change might be the trigger to maximise pension funding this tax year for those likely to be affected. Care should be taken as the lifetime allowance will be reduced to £1M, from 6 April 2016. Be aware of the adjusted income definition rules, as It will be easy for individuals to overlook the impact of employer contributions and think that they're unaffected if their actual income is below £150,000.

What is the tax charge if the annual allowance is exceeded – how is it paid?

The annual allowance tax charge for tax year 2013/14 onwards is a variable charge of up to 45% on the excess pension input amount. From 6 April 2015, the tax charge also applies to those who have flexibly accessed pension funds and exceed their money purchase annual allowance. For tax years 2011/12 and 2012/13 it was a variable charge of up to 50% and before that, a flat tax charge of 40% applied.

The precise tax rate levied is known as the appropriate rate. It depends on the rate of income tax someone pays if the 'excess amount' is included in their taxable income (i.e. broadly income after deducting personal allowances, gross pension contributions, allowable losses, gross charitable donations etc) for the tax year and treated as the top slice of that income. The appropriate rate is:

• 45% on any of the 'excess amount' that falls into the additional 45% income tax* band; 
• 40% on any of the 'excess amount' that falls into the higher 40% income tax* band; and 
• 20% on any of the 'excess amount' that falls into the basic 20% income tax* band.

* In this example do not further adjust the tax bands by the amount of gross member pension contributions.

Example

If Amir has total taxable income of £180,000 in tax year 2015/16. His total pension provision in pension input periods ending in tax year 2015/16 is £3,000 a month personal contributions, plus a £30,000 employer contribution - giving a total pension input amount of £66,000. He has no unused annual allowance available to carry forward from previous years, so he will pay an annual allowance tax charge on the £26,000 excess contributions above his annual allowance. His taxable income for the tax year after deducting his £36,000 personal contributions is £144,000. To work out the appropriate rates of his annual allowance tax charge, the £26,000 excess is added to this so that he's treated as if he has total income of £170,000 subject to income tax.

£20,000 of the excess amount falls into the 45% additional rate income tax bracket. The remaining £6,000 falls into the 40% higher rate income tax bracket. So, Amir's annual allowance tax charge for 2015/16 is £11,400 [(45% x £20,000) + (40% x £6,000)]. He receives income tax relief on his £36,000 contributions.

Paying the charge

The annual allowance tax charge is normally collected through the self-assessment process. If you have been sent a personal tax return but have a liability to pay the charge, notify your tax office. The charge is payable even if the member or any of their pension schemes are not UK resident.

Sometimes the annual allowance tax charges can be paid from pension benefits, saving you from finding the money to pay the tax charge during self-assessment. This wasn't possible pre 2011/12.

Pension schemes can choose to offer this facility in any circumstances. But they are only required to pay the charge on behalf of a member if: the charge is more than £2,000; the pension input amount to that specific scheme was more than the annual allowance*; and the member elects for the charge to be met from their pension benefits under the scheme.

The deadline for the election in respect of a tax charge for 2011/12 was 31st December 2013.

For later tax years, it's 31st July in the year following the end of the tax year to which the charge relates. For example, if a member wants their scheme to pay the charge in respect of 2013/14, the deadline is 31st July 2015.

The member can only require that the scheme administrator pays the charge (or part of it) relating to any excess over the annual allowance under their scheme.

* These 'scheme pays' rules remain unchanged following the introduction of the money purchase annual allowance for some individuals from 6 April 2015.

The effect on pension benefits

If a pension scheme pays the charge (or part of it), the member's fund (or level of benefits) must be reduced accordingly. Failure to do this will lead to unauthorised payment tax charges.

• Money purchase schemes - the member's pension pot will simply be reduced by the amount of the charge paid by the scheme.
• Defined benefit schemes - the charge will be recouped by actuarially reducing the member's accrued pension rights.

For pensions already in payment, there used to be a problem - scheme pensions could only be reduced in limited circumstances, and paying the annual allowance charge wasn't one of them. Doing so would have led to unauthorised payment tax charges. But this changed from 6 April 2013 and scheme pensions now can be reduced to pay the charge.

Guaranteed Minimum Pension benefits can't be reduced to pay the charge. In some circumstances this could mean that the scheme is unable to pay it. If getting a scheme to pay the charge is an option, the member should, of course, contact the scheme provider or trustees to find out what impact this would have on their benefits.

If you think you will be affected by the changes outlined above we recommend you contact your Financial Adviser who will be able to assess your individual circumstances and offer you specific financial advice related to the recent pension changes. Or for more information about the pension services provided by Lonsdale Wealth Management please contact us at: enquiries@lonsdaleservices.co.uk.

Lonsdale Services operate offices in St Albans, Barnet, Harpenden, Leeds, Stafford, and Ware supporting a variety of wealth management and employee benefit clients with financial planning across the United Kingdom.

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