Sarah Bradford looks at the tax reliefs available for pension contributions and asks whether making contributions before the end of the tax year is worthwhile.
In order to have sufficient income to enjoy a comfortable retirement, some forward planning is generally needed; this includes making pension provisions. Tax reliefs are available, and these can be utilised to make pension contributions in a tax-efficient manner.
However, as with all reliefs, there are rules. Furthermore, the costs of getting it wrong can be high. This article looks at the tax reliefs available for pension savings, and also the charges that may arise in certain circumstances if contributions or lifetime pension savings exceed the permitted limits.
Registered pension schemes
Tax relief is only available for contributions to registered schemes – contributions can be made to unregistered schemes, but they do not attract tax relief or count towards the permitted limits on pension savings.
Registered schemes are schemes that are registered with HMRC, and which meet certain conditions.
Tax relief
Tax relief is available on contributions made to registered pensions schemes up to certain limits.
Contributions can only be made up to 100% of earnings or £3,600, whichever is higher.
Furthermore, contributions can only be made to the extent that they are covered by the available annual allowance.
Annual allowance
The annual allowance places a cap on the amount of tax-relieved pension contributions that can be made to registered pension schemes each year. Each individual only has one annual allowance, regardless of the number of pension plans that they have.
The following amounts count towards the annual allowance:
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The total amount paid into a defined contribution scheme by you or by someone (including your employer) on your behalf.
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Any increase in defined benefit schemes in the tax year.
The annual allowance is set at £40,000 for 2021/22. However, the limit is reduced where both of the following apply:
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Adjusted net income is more than £240,000.
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Threshold income is more than £200,000.
‘Adjusted net income’ is, broadly, income including pension contributions, while threshold income is income excluding pension contributions.
Where both these tests are met, a taper applies and the annual allowance is reduced by £1 for every £2 by which adjusted net income exceeds £40,000 until the minimum amount of the annual allowance is reached. This is set at £4,000 for 2021/22.
Example 1: Tapered annual allowance
Rose has threshold income of £220,000 and adjusted net income of £300,000 in 2021/22. As both her adjusted net income and threshold income are above the taper limits, her annual allowance for 2021/22 is reduced.
Her adjusted net income (of £300,000) exceeds £240,000 by £60,000. Her annual allowance is therefore reduced by £30,000, to £10,000.
For 2021/22, anyone who has both threshold income of at least £200,000 and adjusted income of at least £312,000 will receive the minimum annual allowance of £4,000.
Money purchase annual allowance
A lower allowance applies where pension contributions have been flexibly accessed. This allowance, the money purchase annual allowance (MPAA), is set at £4,000 for 2021/22.
The lower limit is to prevent recycling of contributions to take advantage of the tax reliefs.
Carry forward of annual allowances
Where the annual allowance has not been used in full in a tax year, the unused amount can be carried forward for up to three years.
However, allowances for earlier years can only be used once the current year’s allowance has been used. Where earlier years’ unused allowances are used, those from an earlier year are used before those of a later year.
Annual allowance charge
If tax-relieved contributions are made to registered pension schemes in excess of the available annual allowance for the year, the excess tax relief is clawed back in the form of an annual allowance charge.
It should be noted here that the annual allowance does not cap the total amount that can be contributed to a registered pension scheme in a tax year, but the amount of contributions on which tax relief is available. Contributions can be made in excess of the available annual allowance, but these do not attract tax relief.
Relief on excess contributions is clawed back at the individual’s marginal rate of tax.
Lifetime allowance
The second limit on pension savings is the lifetime allowance, which places a limit on the value of benefits that can be taken from a registered pension scheme. The limit is £1,073,000 for 2021/22, and will remain at this level until April 2026.
If lifetime pension savings exceed the lifetime allowance, the excess is taxed at 55%, where taken as a lump sum, and at 25%, where taken as income.
No earnings
Contributions can be made by a person who has no earnings, or by someone else on their behalf, up to £3,600 (gross) each year.
As contributions are made net of basic rate relief, pension contributions of £3,600 will ‘cost’ £2,880, even where the contributor is not a taxpayer.
Obtaining relief
There are different ways in which the tax relief is given.
In a net pay scheme, contributions are deducted from gross pay so that relief is automatically given at the contributor’s marginal rate of tax.
In a relief at source scheme, contributions are made from post-tax income net of basic rate tax. So, for example, a payment of £800 will need to be made for every £1,000 contribution. The pension provider claims the basic rate relief to bring the amount of the contribution up to £1,000.
Where the contributor is a higher or additional taxpayer, relief equal to the difference between the higher or additional rate, as appropriate, and the basic rate is claimed through the self-assessment tax return.
Example 2: Basic and higher rate relief
Lily is a higher rate taxpayer and wishes to make pension contributions of £10,000 to her personal pension scheme in 2021/22.
She makes a payment of £8,000 into the scheme (£10,000 net of basic rate tax of 20%). Her pension provider claims £2,000 and pays it into the scheme. Lily claims a further £2,000 (£10,000 x (40% - 20%)) in relief through her self-assessment tax return. Her contribution of £10,000 costs her £6,000. Relief of £2,000 is given when making the payment and the balance of £2,000 is claimed through her tax return.
As any higher or additional rate relief is claimed through the tax return, there is a delay in receiving that portion of the relief – it is paid initially and claimed back later.
Year end review
As the end of the tax year approaches, it is sensible to review pension provision and consider whether it is beneficial to make pension contributions by 5 April 2022. As with all reliefs, pension tax relief is not a ‘given’; it could be altered or withdrawn by the Government. Consideration could perhaps be given to taking advantage of the reliefs currently.
As unused allowances can only be carried forward for three years, any allowances brought forward from 2018/19 which have not been used by 5 April 2022 will be lost. However, remember that the current year’s allowance must be used before unused allowances from 2018/19 can be accessed.
Before making contributions, consider whether your pension pot is at or near the lifetime limit, to avoid inadvertently triggering a lifetime allowance charge.
Example 3: Unused annual allowance brought forward
Ash has adjusted net income of £200,000 in 2021/22 and an annual allowance for the year of £40,000. He also has unused allowances of £20,000 brought forward from 2018/19, £10,000 brought forward from 2019/20 and £25,000 brought forward from 2020/21. His pension pot is valued at £765,000.
As he inherited some money in 2021/22, he decides to make higher contributions than normal, contributing £80,000. This uses, in order, his annual allowance of £40,000 for 2021/22, £20,000 brought forward from 2018/19, £10,000 brought forward from 2019/20 and £10,000 of the £25,000 brought forward from 2020/21. The remaining £15,000 from 2020/21 is carried forward. Ash has until 5 April 2024 to use this up.
Consideration could also be given as to whether to make contributions on behalf of non-earners or low earners to assess the tax relief attached to minimum contributions.
Practical tip
Review pension savings and available allowances prior to 5 April 2022, in order to assess whether it is beneficial to make pension contributions before the end of the tax year to take advantage of available reliefs.
