When it comes to the tapered annual allowance for pension contributions, examples help to bring clarity to this often misunderstood area of pensions. Here are three tapered annual allowance examples to help you get clarity on your finances.
What is the tapered annual allowance?
The tapered annual allowance was introduced from 6th April 2016 to reduce the tax benefits available to high earners by reducing the amount of tax relievable pension contributions they can make in any one tax year. It helps to ensure that high earning individuals are not able to obtain a large amount of tax relief on their accumulation of retirement wealth, by reducing the amount they are able to contribute once they earn over certain thresholds. To understand more about your annual allowance, read our short guide below.
How does tapered annual allowance work?
Tapered annual allowance applies if you have a “threshold income” of more than £110,000 and an “adjusted income” of more than £150,000. For the taper to apply to you, you must exceed both thresholds. In doing so, your annual allowance will be reduced by £1 for every £2 of adjusted income over £150,000. The trick therefore is knowing how to work out the difference between your threshold income and adjusted income.
What is threshold income?
Threshold income is essentially your total income for the year, minus any pension contributions that have been deducted from your employment income. Note that threshold income is a measure of your total income. Your calculations must include any income from things like buy-to-let properties, dividends and interest on savings.
Beyond pension contributions, there are additional items that can be deducted from your threshold income, such as lump sum pension death benefits.
Find out more about threshold income
What is adjusted income?
If your threshold income exceeds £110,000, it’s time to calculate the value of your adjusted income. To do that you again start with your total income for the year. Then add the total contributions to your pension scheme. If your adjusted income exceeds £150,000 your annual allowance for that tax year will be reduced.
Find out more about adjusted income
Calculating your annual allowance
Your annual allowance is the maximum tax-free pension contribution that you can make in a given tax year. That figure is set at £40,000. But if you exceed the limits for threshold income and adjusted income, your annual allowance will be reduced.
The maximum reduction to your annual allowance will be £30,000, for which you will need to be £60,000 over the adjusted income limit. Essentially it means that if your adjusted income is £210,000 or more, you will have an annual allowance of just £10,000. Contributing more to your pension than this will incur tax charges. Let’s look at some examples.
Example 1: Mark
Employment income: £80,000
Rental income: £30,000
Dividends income: £1,500
Personal pension contributions: £10,000
Employer pension contributions: £10,000
Threshold income: £101,500 (£80,000 + £30,000 + £1,500 – £10,000)
Adjusted income: £131,500 (£80,000 + £30,000 + £1,500 + £20,000)
Neither Mark’s threshold income nor adjusted income exceeds the permissible limit. Therefore his annual allowance remains the same at £40,000.
Example 2: David
Employment income: £130,000
Dividends income: £10,000
Personal pension contributions: £13,000
Employer pension contributions: £12,000
Threshold income: £127,000 (£130,000 + £10,000 – £13,000)
Adjusted income: £165,000 (£130,000 + £10,000 + £25,000)
David exceeds the limits for both threshold income and adjusted income. Therefore an adjustment must be made to his annual allowance, which is reduced by £1 for every £2 of adjusted income over £150,000.
As David is £15,000 over the adjusted income limit, his £40,000 annual allowance is reduced to £32,500. Any pension contributions beyond this limit will incur tax charges.
Example 3: Rebecca
Employment income: £200,000
Rental income: £20,000
Personal pension contributions: £20,000
Employer pension contributions: £20,000
Threshold income: £200,000 (£200,000 + £20,000 – £20,000)
Adjusted income: £260,000 (£200,000 + £20,000 + £40,000)
Like David, Rebecca exceeds the limits for both threshold income and adjusted income. Her adjusted income is £110,000 over the permissible limit. Yet because the maximum reduction to annual allowance is £30,000, her annual allowance is reduced to £10,000 from £40,000. Any pension contributions above £10,000 will incur tax charges.
Taking advantage of the carry forward rules
Each year you are given a maximum tax-free pension contribution of £40,000. However if you don’t use that full allocation, you can carry forward the unused amount to the next tax year, and so on. This allows you to offset sudden spikes in income to avoid additional tax charges.
Pension contributions and tax can be complicated. We can help.
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