The whole PensionMan thing is that personal finance doesn’t have to be difficult or confusing. What makes it appear so is the liberal use of jargon and the inability of most finance professionals to express themselves clearly in plain English.
However, as with every good rule, there is an exception which proves it. For pensions this exception relates to the tapering of the annual pension contribution allowance for high earners.
So what does that even mean? Well ordinarily people are permitted to contribute up to £40,000 to their pensions each year. However, if someone earns over a certain threshold, the allowance is progressively cut to just £10,000.
Now it’s not totally unreasonable for the government to want to curb the amount of tax relief high earners receive on the pension contributions. The problem is the complete dog’s dinner it has made of translating this desire into policy.
HMRC uses not one but two distinct definitions of income to determine whether your annual pension contribution allowance should be cut.
The good news is that both have to be exceeded for your allowance to be tapered. The bad, is that at least one, and quite possibly both, are apt to be significantly higher than your basic salary.
This means that although the taper is supposedly targeted only at very high earners, it is surprisingly easy to be affected.
Ok so what are the two measures of income?
The first is “threshold” income, which, broadly speaking, consists of your base salary, plus any bonus you might be paid and most forms of investment income (such as dividends or from buy-to-let), minus any personal pension contributions you have made.
If this is greater than £110,000 it is then necessary to look at your “adjusted” income.
Just as with threshold income, your adjusted income includes your salary, bonus and any investment income you may have received. Crucially though you must also add any pension contributions made on your behalf by your employer. Worse still, unlike threshold income, you can’t deduct any personal pension contributions you may have made.
Still with me?
The rule is that if your adjusted income is greater than £150,000 (assuming your threshold income has already been established as being greater than £110,000) then your allowance is reduced by £1 for every £2 of adjusted income above £150,000.
Put simply, if your adjusted income exceeds £210,000, your annual allowance will be cut right down to the minimum of £10,000.
The worst case scenario is that you and your employer have already contributed the full £40,000 in a given tax year, but subsequently discover that your earnings are such that your annual allowance has been tapered to £10,000. The resulting £30,000 excess will be taxed at 45%, producing a tax bill of £13,500. Ouch!
Again it is surprisingly easy for this to occur because many people won’t know how much they have earned until well after the end of the tax year.
What to do if you think you might be affected
Even this summary is a gross over-simplification of the tapering issue, so, if you think you might be affected, it is probably worth taking financial advice. For the “confident” though, there are plenty of materials online to help you calculate your own adjusted and threshold incomes.
Your employer should be able to help with your earned income. The problem is that, generally speaking, they will have no idea of what your non-employed income is.
If you do find that you are affected by the limit, it might be possible to carry forward unused annual allowances from up to three years prior. However, these allowances may also be subjected to tapers. In that case the carried forward allowances might not be as large as they would have been had you contributed in the year in question.
So what happens if you have paid too much into your pension?
If you owe tax due to a tapered contribution allowance, there is a provision for your pension scheme to pay the tax under so-called “scheme pays” rules. This spares someone from having to find the cash to pay the tapering tax bill. Instead it is simply deducted directly from their pension fund.
The problem here is that it is not mandatory for a scheme to offer this facility. And even schemes which allow “scheme pays” for contributions in excess of £40,000, don’t necessarily oblige where the bill is triggered because the annual allowance has been tapered below £40,000.
In any case, a bill of less than £2,000 is automatically collected by adjusting your PAYE tax code.
A ludicrous situation can occur for someone who is also affected by the tapering of their personal income tax allowance. This allowance is progressively removed for earnings above £100,000, again at the rate of £1 for every £2 of income. If that person (or their employer) has also made the maximum £40,000 annual pension contribution, they may actually be better off making a further pension contribution, even though excess pension contributions attract a tax charge of 40%.
The is because the progressive removal of the personal income tax allowance for earnings between £100,000 and £123,000 effectively increases your marginal tax rate to 60%. So by making additional pension contributions you swap a 60% tax charge for a 40% charge, leaving you 20% better off for that portion of your earnings.
That’s a lot to get your head around I know, but it does show how rubbish the system can be at times!
The good news though, is that if you can understand that, you can understand anything!
Take care out there