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How Does the Pension Annual Allowance Work in the UK?

Every tax year, the government sets the pension annual allowance or the maximum amount of money a person can contribute to their pension savings and still receive tax relief. For the current tax year (6 April 2023 – 6 April 2024) the annual allowance stands at £60,000.
But what if a person would like to pay in more? They are welcome to, however, once their contribution goes above the annual limit, they are obliged to pay tax. How exactly does it work? We reveal this in our article.

Understanding Pension Annual Allowance

First, let’s have a closer peek at how the private pension contributions system functions in general.

Types of Pension Contributions Included

There are two types of private pension schemes available in the UK:

  • The defined contribution pension scheme is based on how much money is contributed and how well this money performs as investments;
  • The defined benefit pension scheme is based on your salary and length of service.

Basics of Annual Allowance Calculation

As we’ve already figured out, there is a £60,000 limit on the amount of your annual private pension contributions. This amount comprises your own contributions, your employer’s contributions, and any other 3rd party’s contributions. Let’s say, if you have both personal and workplace pensions, the limit for each of them will be £30,000. It’s worth mentioning that tax relief also counts, as it increases each contribution. This fact should be considered to avoid exceeding the annual allowance threshold.

The annual allowance calculations are very individual as they depend on contributions. To calculate it, you should consider:

  • Your annual salary;
  • Your workplace pension contribution (a minimum of 5% starting from April 2019);
  • Your employer’s contribution (a minimum of 3% starting from April 2019);
  • Tax relief;
  • Your contribution to your private pension pot.

Implications for High Earners

Should your annual earnings exceed the £220,000 threshold (also known as ‘threshold income’), and your adjusted gross income (an individual’s taxable income after accounting for deductions and adjustments) is more than £260,000, your annual allowance decreases. This is called the ‘tapered annual allowance’.

Tapered Annual Allowance Explained

So, if your adjusted income is between £260,000 and £360,000, you will lose £1 of annual allowance for every £2 of the income you have over £260,000. The maximum reduction reaches £50,000, therefore, individuals who make over £360,000 have a reduced annual allowance of only £10,000 (starting from April 2023). This is known as the minimum taper.

Impact on Individuals with High Incomes

We’ve created a table to show how the annual allowance is reduced if your income goes beyond the £260,000 threshold:

  • Total adjustable income: £260,000, Annual allowance: £60,000
  • Total adjustable income: £270,000, Annual allowance: £55,000
  • Total adjustable income: £300,000, Annual allowance: £40,000
  • Total adjustable income: £330,000, Annual allowance: £25,000
  • Total adjustable income: £350,000, Annual allowance: £15,000
  • Total adjustable income: £360,000, Annual allowance: £10,000

In case an individual falls into the category of high earners, they have several options to resort to:

  1. Reduce the contributions and meet the set limits.
  2. Deal with an annual allowance charge. We’ll talk about it a bit later.

Navigating Carry Forward Rules

In case you haven’t used up your annual allowance in the three previous tax years, you are allowed to carry it forward and add it to the annual allowance for the current pension input period. You also don’t need to report this to HMRC. Let’s break it down.

Utilizing Unused Annual Allowance

First, let’s have a look at the key requirements for the ‘carry-forward’ program:

  • Individuals who are on the Money Purchase Annual Allowance aren’t allowed to carry their annual allowance forward;
  • Individuals who are willing to carry forward unused allowances from a tax year where they were not a member of at least one UK-registered pension scheme (this does not include the state pension) or a qualifying overseas pension scheme aren’t allowed to carry their annual allowance forward;
  • Individuals who are willing to carry their annual allowance forward must earn at least the amount they want to contribute in total this tax year (unless their employer is contributing).

How Carry Forward Works

Provided that an individual meets all the standards mentioned above, this is how the carry-forward opportunity can work for them in practice. For instance, in the 2020/21, 2021/22, and 2022/23 tax years, an individual paid yearly £30,000 into their pension pots instead of £40,000, which was the annual allowance limit. Now, they are allowed to carry forward a total of £30,000 (which is 3 times £10,000 from each of the previous three years) to the current tax year and increase their annual allowance up to £90,000 (where £60,000 is the current limit and £30,000 is carried forward).

Considerations for Different Pension Savings Schemes

In the UK, individuals are allowed to have several pension savings schemes. But as we’ve already mentioned, your total pension contributions cannot exceed the £60,000 limit.

Defined Contribution Pension and Annual Allowance

Also known as ‘money purchase’ pension schemes, are usually arranged either by you (private pensions) or by your employer (workplace pensions). This money is put into investments. The overall outcome depends on several factors:

  • How much money is contributed;
  • How your investments perform (the value of the pension pot may either go up or down);
  • How you withdraw your money (as regular payments, a lump sum payment, or smaller sums).

25% of your pension pot is tax-free, while the remaining 75% is subject to income tax. The tax rate normally depends on your overall income.

You’ll also have to pay a small fee to your pension provider for managing your pension savings.

Defined Benefit Pension and Annual Allowance

Also known as ‘career average’ or ‘final salary’ pensions, defined benefit pension schemes are arranged by the employer. The amount of savings will depend only on your pension scheme’s terms. Those comprise the salary and the length of service. Similar to the defined contribution scheme, you get 25% of the amount tax-free and the rest is subject to tax. Once a person retires, a certain amount of money is paid out annually as their pension allowance.

Tax Consequences of Exceeding Allowance

Last but not least: what happens to those who go above and beyond the annual allowance limit? We unpack it for you here.

Tax Relief for Annual Allowance

Exceeding the £60,000 limit results in such implications:

  1. Pension tax relief cancellation;
  2. Receiving the additional tax bill called the annual allowance charge.

On the bright side, one doesn’t have to pay a fine directly. The charge is added to the rest of their taxable income for the year in question.

However, there are some exceptions to these terms:

  • You can still claim tax relief for pension contributions on their Self Assessment tax return, even if they’re above the annual allowance: 20% up to the amount of any income they have paid 40% tax on or 25% up to the amount of any income they have paid 45% tax on.
  • HMRC does not tax individuals for going over their annual allowance if they retire and take all their pension savings because of serious health issues or in case of their death.

Strategies to Manage Tax Implications

In case you accidentally faced tax implications connected with your annual allowance, there are some ideas on how to manage them:

  • Check if you have any unused annual allowance from the previous three tax years and carry it forward to the current tax year.
  • Optimise your contributions. Ensure that you and your employer are on the same page regarding your inputs. This will help you stay within the limit and prevent tax penalties.
  • Diversify your investments. Besides your pension savings, consider the opportunities for alternative investment options.
  • Seek advice from professionals to make the most informed decisions possible and protect yourself from any undesirable tax liabilities.
  1. GOV.UK Types of Private Pensions
  2. GOV.UK Workplace Pensions
  3. GOV.UK Tax on your private pension contributions
How Does the Pension Annual Allowance Work in the UK?
Date: 7 February 2024
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