High earners should be particularly mindful of the annual allowance, as exceeding it can lead to unexpected tax liabilities at the end of the tax year. The annual allowance is the maximum amount you can contribute to your pension each year without incurring tax charges.
What is the Annual Allowance?
For most individuals, the annual allowance is set at £60,000. If your income is less than this amount, the maximum personal pension contributions you can make is equivalent to your total relevant UK earnings. However, if you exceed this limit, a tax charge may be triggered. This isn’t technically a “penalty” but can still come as an unwelcome surprise, making it difficult to manage without proper planning.
If you or your employer contribute more than the annual allowance into your pension, the pension provider will automatically apply basic rate tax relief at source. For employer contributions made through salary sacrifice, you will receive immediate income tax relief as well as National Insurance relief directly into your pension. However, if overpayments are made, HMRC will attempt to reclaim some of the tax relief at the end of the year. While your funds remain in the pension, accessing them to cover the tax bill can be complicated.
The Tapered Annual Allowance
High earners may also be affected by the tapered annual allowance. If your total income exceeds £260,000 a year, your annual allowance will reduce. This includes income from all sources, such as salary, bonus, and employer pension contributions. If your income falls between £200,000 and £260,000, you should still be cautious, as other income streams might push you over the threshold.
The tapering reduces your annual allowance by £1 for every £2 earned above £260,000, down to a minimum allowance of £10,000. For example, if your total earnings and employer contributions add up to £300,000, you’ll be £40,000 over the threshold, reducing your allowance by £20,000. This means the most you can contribute to your pension that year would be £40,000, not the full £60,000.
For those with incomes as high as £360,000, the annual allowance could be reduced to the minimum of £10,000. In such cases, it may be worth discussing alternative ways of building retirement funds with your employer, such as receiving additional income instead of further pension contributions.
The Annual Allowance and Carry Forward
If you’ve exceeded your annual allowance for the current tax year, you may be able to use unused allowance from the previous three years through the carry forward option. However, there are some key considerations:
- You cannot contribute more than your relevant UK earnings, even if your carry forward allowance exceeds your current year’s income. For example, if you have £100,000 of carry forward available but only £80,000 in earnings, you can’t contribute the full £100,000 and would lose £20,000 of the available carry forward.
- The tapering rules also apply to carry forward. Previously, tapering started at £150,000 of income in earlier tax years, but it has since been increased to £260,000 as of the 2021/22 tax year.
Is the Annual Allowance Affecting You?
As you can see, understanding the annual allowance and how it impacts high earners can be complex. If you find yourself affected by the rules, it’s essential to work with a financial planner to avoid unexpected tax liabilities and to ensure your retirement planning remains on track without causing unnecessary financial stress.
