Interaction of tax relief and annual allowance

Author Image The Technical Team
20 minutes read
Last updated on 18th Sep 2018

Overview

Tax relief rules and annual allowance rules work separately. Both sets of rules must be correctly considered to ensure pension savings are tax efficient.

Key Points

  • You don’t deduct employer contributions or Defined Benefit Pension Input Amounts (DBPIA) from relevant earnings to work out the client’s maximum personal contribution for tax relief
  • Annual allowance is not restricted to a client’s relevant earnings
  • Employer contributions are not restricted by relevant earnings or annual allowance
  • Tax relief on an employer contribution is limited by the wholly & exclusively rule
  • If an employer contribution exceeds the client’s available annual allowance the employee pays the AA excess tax charge
  • The AA limit applies to the total monetary value of all defined contribution amounts paid by or on behalf of an individual (includes 3rd party and employer contributions) plus the pension input amounts for any defined benefit schemes.

Limits for pension contributions

Pensions simplification removed some complex rules and multiple maximum benefit calculation regimes that existed prior to 6 April 2006 and replaced them with some new rules for tax relief, annual allowance and lifetime allowance.

In this article we aim to clarify some common misconceptions on the tax relief and annual allowance rules.

Tax relief - test 1 of 2

Our Tax relief on member contributions and Tax relief on employer contributions articles look at the tax relief rules in isolation. These rules let you work out when tax relief will be available for individual and/ or employer contributions. 

We know that a member can receive tax relief on contributions up to the higher of £3,600 or 100% of relevant earnings in the tax year they pay the contribution. This limit applies to the gross amount of pension contribution rather than the amount actually paid by the member. You need to know the method of tax relief used by the scheme to work out the maximum amount the member can pay. For instance with a RAS contribution the maximum a member can pay is 80% of the gross amount allowed, as detailed below.

Relief at source

'Relief at source’ (RAS) works by the member paying a contribution amount less basic rate tax deduction, ie a member pays £80, the pension provider claims £20 from HMRC and adds a total of £100 to the member’s pension pot. The rationale for this is that payments to a RAS scheme are generally made from taxed income, so the additional amount from HMRC will give you basic rate tax back.

Member with £20,000 salary is entitled to tax relief on a contribution up to 100% of relevant earnings. Using RAS this means a maximum contribution of £16,000 net from the member. Once the basic rate tax relief (£4,000) is claimed by the pension provider the total gross pension contribution is £20,000.

Net pay

Net Pay gives “tax relief” by allowing a tax saving. This is done by taking the pension contribution from the members pre-tax income, so (for earnings over the personal allowance) a £100 net pay contribution for a basic rate taxpayer would reduce their take home pay by £80.

For a member with £20,000 salary over and above their personal allowance, paying a gross contribution of £20,000 means they save the tax ordinarily due in respect of these earnings. Total salary less their gross personal contribution leaves the amount to be taxed and, as this falls within the personal allowance, the tax rate is 0%. 

For low earners who are members of a Net Pay scheme, even if it is an affordable option, it may not be worth making a pension contribution of 100% of earnings. You’d need to check for any other benefits to be gained, for example, guaranteed annuity rates, employer matched contributions or the purchase of additional years pension benefits, that would make contributions worthwhile, even with no tax relief.

Making a ‘Claim’

Making a ‘Claim’, usually by self-assessment, works by reducing the client’s income subject to tax and so reducing the tax bill. Clearly if there is no tax due then there is no tax relief available.

For a member with £20,000 salary, their pension contribution is deducted before they pay tax. A contribution of the amount between their personal allowance and their taxable earnings will reduce their tax bill. They could choose to pay a larger pension contribution, however, as there is no tax due on earnings up to the personal allowance, there is no further tax relief to claim.

Comparison of tax relief using each method

  Relief at source  Net pay/Make a claim 
Taxable earnings over personal allowance

Less gross contribution
Tax due at 20%
£1,000

0
£200 
£1,000

£2,000
0 (£200 saved here) 
     
Net contribution/ cost from take home pay

Plus tax relief
Total Pension Pot
£1,600

£400
£2,000 
£1,800

£0
£2,000 
     

The difference is, using RAS there is an additional £400 added to the member’s pension plan even though the member’s tax bill was only £200. Using Net pay/ make a claim, there is no additional tax relief from HMRC over and above the £200 saved by the contribution increasing the personal allowance by £1,000.

Salary sacrifice

An employee could also save income tax, and National Insurance Contributions (NIC), by using a salary sacrifice agreement. This is where they have a contract with their employer to exchange some of their gross salary (before tax) for a non-cash benefit, such as an employer pension contribution.

They get ‘tax relief’ simply by not receiving part of their salary and therefore not paying income tax in respect of the amount given up. Similar to the Net pay/ Make a claim information above, there is no additional tax relief from HMRC added to the pension contribution. Depending on the terms of the salary sacrifice arrangement, the member may benefit from some, or all, of the amount of employer’s NIC saving which the employer may agree to pass on by an increase to the contribution amount.

Where salary sacrifice takes place, it is only the taxable amount of salary the member actually receives which is relevant earnings if they are looking to make additional personal contributions.

Using the limit

When you are working out the maximum an individual can contribute, you must take into account any other personal contributions they pay, eg to an occupational scheme (includes defined benefit and CARE schemes and this would be the monetary amount they pay NOT the accrual of benefits (that’s used for the AA later)), an auto-enrolment scheme, any AVC scheme, personal pension plan, S226 contributions etc.

You would not deduct employer contributions or defined benefit pension input amounts. Employer contributions work under the corporation tax relief regime so do not impact on the tax relief rules for personal income tax calculations.

At 6 April 2006 HMRC decided unused tax relief can no longer be carried backwards or forwards to other tax years. This position remains the same to date. The ‘carry forward’ introduced in tax year 2011/12 relates to unused annual allowance NOT tax relief.

Common questions we hear,

  • Can my client pay an individual contribution in excess of their relevant earnings using carry forward rules?
  • My client has no relevant earnings, can they contribute £3,600pa for this and the 3 previous tax years using carry forward?
  • My client had relevant earnings of £60,000 in the last tax year but £0 this tax year, can they contribute £40,000 using carry forward?

As you cannot carry forward unused tax relief the answer to all of these questions is there will be no tax relief on any contribution which exceeds the greater of £3,600 or 100% of relevant earnings in the tax year the contribution is paid. The contribution may still be paid (depending on the scheme/ provider being able to accept it) and, if it is paid, it will use annual allowance. Whilst employer contributions don’t count towards the limits for individual tax relief, they do count towards the annual allowance - covered later.

Lydia - an example of tax relief rules

Lydia has relevant earnings of £26,000. She pays 5% of salary as an employee contribution and her employer pays 10% to their group personal pension scheme. What is the maximum additional contribution Lydia can pay?

The answer is £24,700 gross.

Lydia currently pays 5% of her salary which is £1,300, this leaves her with £24,700 relevant earnings to support an additional personal contribution. You ignore her employer’s contribution when working out Lydia’s maximum personal contribution for tax relief. 

Annual allowance – test 2 of 2

Tax relief limits are only part of the story, generally, it is not wise to look at tax relief in isolation. Although those rules let you work out when tax relief will be available for individual and/ or employer contributions, you also need to consider the separate annual allowance (AA) rules. Where total pension savings exceed the relevant AA limit (which includes any available carry forward) then there may be an AA charge. This charge can reduce, negate or exceed any tax relief initially given. 

In the current tax year the standard annual allowance is £40,000, this can be lessened in 2 circumstances:

  1. If a member is subject to a Tapered Annual Allowance (TAA), this reduces the AA somewhere between £10k and £40k depending on the adjusted income figure.
  2. If the client has flexibly accessed pension benefits then within either the standard or TAA limits, they will be subject to the £4,000 limit for money purchase contributions.

A TAA replaces the standard AA for ALL pension savings in the tax year it applies to.

The MPAA does not replace the standard AA or TAA, it simply limits defined contributions (DC)/ money purchase contributions. Any remaining standard AA or TAA (called alternative annual allowance) can be set against pension savings other than DC/ money purchase pension savings, eg DBPIAs.

The AA is not limited by relevant earnings.

Total Pensions Savings

For a money purchase scheme, the monetary value of both employee and employer contributions (including any employer contributions arranged as part of a salary sacrifice agreement) count towards the AA limit. For a defined benefit or CARE scheme, instead of actual monetary values of member and employer contributions, it’s the defined benefit pension input amount that is used in the AA test.

There are a few exclusions covered in Pensions Tax Manual.

Unused annual allowance

Carry forward was introduced in tax year 2011/12 when the AA dropped from £255,000 to £50,000. Its purpose is to try and reduce the impact for those members who might have a spike in pension savings due to salary rises during a pension input period.

This is not a reintroduction of the old carry forward/ carry back which used to apply for tax relief. It was a brand new concept and works exclusively with the AA rules. It has a similar name but a totally different identity.

You check the tax relief limits first, then the amount of annual allowance available. Where a member’s total pension savings (see earlier for what may be included) exceed their available Annual Allowance, {NB this may be the standard Annual Allowance (AA), Money Purchase Annual Allowance (MPAA) or Tapered Annual Allowance (TAA)}, check for any available carry forward from the three earlier tax years that could be used to reduce the excess amount.

Importantly, the AA limit is not capped by relevant earnings where these are below £40,000. It is entirely possible for a member to have available AA but insufficient relevant earnings to make tax relievable pension contributions of the amount required to use all their AA in the current tax year.

To recap, tax relief for individual contributions is limited by relevant earnings (test 1). The amount of employer contribution is not relevant to this calculation. It’s the annual allowance test (test 2) that looks at all pension savings made by, or on behalf, of a member and this does include employer money purchase contributions and any defined benefit pension input amount for any active member of a defined benefit pension scheme.

Mike - an example of AA rules

Mike has relevant earnings of £35,000. He has paid a personal contribution of £20,000 gross which his employer has matched. Does Mike have an annual allowance excess?

Providing Mike has the standard AA (ie he is not subject to TAA or MPAA), the answer is no.

Mike’s total pension savings are his personal contribution of £20,000 plus his employer’s contribution of £20,000 so £40,000 AA used and no excess.

Incidentally, if Mike has £15,000 of unused AA to carry forward he would be able to contribute £35,000 and still receive tax relief (if paid to a RAS scheme). His employer contribution would then use the remaining £5,000 from this year and the £15,000 carry forward and, again, this means there’s no AA excess.

Case studies

Case studies for both tests

  1. Joe - self employed

    Joe is self-employed with taxable profits of £33,000 in the current tax year. What is his maximum pension contribution and can he use carry forward?

    Tax relief

    Joe is entitled to tax relief on a personal contribution up to 100% of his relevant earnings in the tax year the contribution is paid (as his relevant earnings are above £3,600). This means he can pay £26,400 net to a personal pension scheme operating Relief At Source (RAS). The pension provider will claim basic rate tax relief from HMRC, and add this to Joe’s pension, meaning a gross contribution of £33,000 is invested.

    Annual allowance

    Joe has the full standard AA of £40,000. If he pays a personal contribution of £33,000 gross then this uses £33,000 AA and leaves £7,000 unused AA which can be carried forward and used in a later tax year.

    Joe’s AA for the current tax year is not limited to his relevant earnings. He actually has available AA but no more relevant earnings to make any additional tax relievable pension contribution in the current tax year.

    It is only tax relief for Joe’s individual contribution that is limited by his relevant earnings.

    Planning for next tax year

    Moving on to the next tax year, let’s assume Joe then has taxable profits of £47,000. His maximum personal contribution will be 100% of his relevant earnings in that tax year, ie £47,000 gross.

    Where total pension inputs in a tax year exceed the member’s AA, then Joe should look back to the previous three years to work out if he has any unused AA to carry forward. He’ll have that tax year’s allowance of £40,000 plus he’s got £7,000 that he hasn’t used, giving a total AA of £47,000.

    If he pays a personal contribution of £47,000 gross, this will use £47,000 AA. Although pension inputs exceed the AA, there is no AA excess charge as carry forward can be used to fully absorb total pension input amounts (PIA).

  2. Sky - member of employer’s GPP scheme

     
    Sky has relevant earnings of £20,000. Her employer’s pension scheme is a group personal pension arrangement which operates RAS, and her employer pays £2,000 as a pension contribution.

    Tax relief

    Sky is eligible for tax relief on a personal contribution up to £20,000 gross.

    Sky’s maximum personal contribution to this scheme would be a net contribution of £16,000, which would be grossed up to £20,000 in the pension when the provider claims 20% (£4,000) tax relief from HMRC. She’d still have to pay some tax but would have £4,000 added to her pension pot, and overall this would mean a net gain from HMRC.

    Annual allowance

    Sky has the full AA of £40,000. If she pays a personal contribution of £20,000 gross and her employer pays £2,000 then this uses £22,000 AA and leaves £18,000 unused AA which can be carried forward and used in a later tax year.

    Sky’s AA for the current tax year is not limited to her relevant earnings. She actually has available AA but no more relevant earnings to make any additional tax relievable pension contribution in the current tax year.

    It is only tax relief for Sky’s individual contribution that is limited by her relevant earnings.

  3. Doug - active member of a Defined Benefits scheme

    Doug is an active member of his employer’s defined benefit pension scheme. Doug pays a 3% employee contribution based on his pensionable salary of £37,500.

    Working out the maximum individual pension contribution for a client who already contributes to their employer’s defined benefit scheme can be tricky. The usual two calculations will be required, checking tax relief limits then available annual allowance.

    Defined benefits and the MPAA

    A member with a defined benefit pension (either accruing benefits or receiving DB pension benefits) is broadly unaffected by the MPAA. You can read more about the MPAA in our technical centre. Taking a pension commencement lump sum and scheme pension from a defined benefits scheme does not trigger the MPAA for future pension savings.

    If your client has flexibly accessed money purchase benefits and triggered the MPAA, any defined benefit pension input amounts are NOT tested against the MPAA. These are tested using the alternative annual allowance (the standard annual allowance, or tapered annual allowance where one applies, less defined contribution inputs paid up to £4,000 for the current tax year), including any available carry forward of unused annual allowance.

    Tax relief

    As always, the first consideration is tax relief and the usual limits apply - up to £3,600 gross pa, or 100% of relevant earnings in the tax year if greater. You must take in to account any personal contributions they already pay to any other pension scheme.

    This means Doug already pays £1,125 to the Defined Benefits scheme therefore, to be eligible for tax relief, he can only pay up to a maximum of (£37,500 – £1,125) £36,375 gross to a personal pension plan.

    Annual allowance

    Next you should check for available annual allowance. Does your client have the standard annual allowance or are they subject to a tapered annual allowance? Have they triggered the money purchase annual allowance which applies to defined contribution savings? What are the pension input amounts for any other pension saving made in this tax year? For a Defined Benefit scheme it is the increase in pension entitlement for the year multiplied by 16 rather than the monetary contribution amount that is tested against the Annual Allowance. Full details of this calculation are set out in HMRC guidance

    Now compare the proposed personal contribution amount with the available annual allowance. You’ll have two possible outcomes. Either the individual will have sufficient remaining annual allowance (including carry forward where eligible) to absorb the proposed new contribution amount or, they won’t.

    We’ll say Doug’s defined benefit pension input amount (DBPIA) for the current tax year is estimated at approximately £11,000. It is not possible to get a definite DBPIA figure until the end of the pension input period/ tax year, when the pensionable salary at that date will be known.

    If Doug has fully used his annual allowance for previous years, so has no unused AA to carry forward, his available annual allowance is £40,000 less the defined benefit pension input amount for the current tax year of £11,000 leaving £29,000

    Comparison

    The remaining annual allowance is less than £36,375. This means Doug could pay up to £36,375 and receive tax relief on the whole amount. However, you know that his total pension savings would then exceed his available annual allowance and Doug would have to report the excess above his available AA and declare the related tax charge. An AA excess/ charge reduces the tax efficiency of making this level of personal contribution.

    In this scenario it may be more appropriate to limit the individual pension contribution to £29,000 gross as this will receive tax relief without causing any annual allowance excess.

  4. Maggie - business owner

    Maggie owns her own business and is looking to make a large employer contribution to her personal pension in the current tax year. Employer pension contributions are unlimited so she’s planning on a contribution of £200,000, is this okay?
    Again the two areas to consider are tax relief and annual allowance. 

    Tax Relief

    As detailed in our ‘tax relief on employer contributions’ article , an employer pension contribution will receive tax relief based on whether or not the amount paid satisfies the definition of being an allowable deductible expense wholly & exclusively (W&E) for the purposes of the trade (expenses of management if paid by an investment company). 

    The company accountant is best placed to guide the employer on how much is reasonable. If HMRC were to challenge the contribution amount, then it is the accountant who would need to justify it.

    The tax relief rules for employer pension contributions do not include any link to the client’s relevant earnings (this only applies to individual contributions paid by the member or paid on their behalf by a 3rd party e.g. as a gift from a parent etc). Neither is there any link to the client’s available annual allowance. So in a case for an employer who pays a pension contribution of £200,000 and this is deemed to meet the W&E rule, then it will receive corporation tax relief.

    This is the end of the story for the employer. Maggie’s business will receive corporation tax relief in respect of the whole £200,000 contribution. What happens next does not change this position. 

    Annual Allowance

    Remember all employer pension contributions are tested against the member’s annual allowance. Even if the full contribution did not qualify for corporation tax relief, it still uses up Maggie’s annual allowance. 

    Maggie has been building up her business over the last 10 years and now wants to focus on pension planning. She started a pension plan for the first time in the current tax year. Her taxable income (salary and dividends) amounts to £50,000 so she is unaffected by the tapered annual allowance (as an employer contribution does not affect the Threshold Income measure for the Tapered AA, so she will not be over the £110,000 of Threshold Income) and at age 48 she’s too young (and healthy) to have flexibly accessed her pension benefits so is not subject to the money purchase annual allowance.

    The standard annual allowance is £40,000. As Maggie was not a member of a registered pension scheme before this tax year she has no unused annual allowance to carry forward. This means she has an annual allowance excess of (£200,000 contribution - £40,000 allowance) £160,000. This is taxable on Maggie as an individual, even though the company made the contribution, it’s the member’s responsibility to report and arrange payment of the AA charge.

    Maggie must report this excess in a self-assessment tax return. To calculate the relevant tax charge, the AA excess is added to other income to determine the tax rate which applies. Although the charge is to income tax, the amount is not income for tax purposes and therefore the member cannot offset any allowances, losses or relief against it. Similarly it will not lead to a loss of allowances, such as losing the personal allowance.

    Using rest of UK rates the charge would be £100,000 x 40% and £60,000 at 45% a total of £67,000. Maggie can pay this herself or ask her pension scheme to pay the charge on her behalf by reducing the benefits in her pension. Either way the £200,000 pension contribution is effectively reduced to £133,000. There is still a net benefit so it’s not all bad, however, there may have been other options she would have considered had she been warned about the annual allowance excess before the contribution was paid.

    Alternatively, some early planning a few years ago could have increased Maggie’s current options. It’s not uncommon to see clients in the same situation. Even if they don’t want to, or don’t have the means to, actively pay into pensions now, if they want the opportunity to pay large contributions in future, they need to plan correctly. If Maggie had paid a nominal amount in to a pension four tax years before the current one, she’d be able to carry forward unused annual allowance (up to £40,000pa) from then for each of the three previous tax years to reduce her current annual allowance excess. 

    Employer contributions are not limited to relevant earnings or annual allowance. Tax relief is based on the contribution satisfying the wholly & exclusively rule. Maggie’s business gained full corporation tax relief, but as the contribution exceeded Maggie’s available annual allowance, it is Maggie who must report and arrange payment of the AA excess charge.

Important notes

As always, there will be exceptions to the rule. There may still be a net overall benefit for an individual to pay a personal contribution that actually causes them to have an annual allowance excess. A few planning angles could include an individual wanting to pay a larger pension contribution to get them out of the child benefit or personal allowance tax traps, or to reduce their threshold income to avoid a tapered annual allowance etc. 

You always need to apply the tax relief rules to work out the maximum personal contribution which would be allowed tax relief, but it is equally important to go on to check the available annual allowance. Doing both tests, and possibly revising the plan within the tax year if appropriate, is the only way to ensure any pension savings are made as tax efficiently as possible.

One final reminder, individuals cannot carry forward unused tax relief. 

Labelled Under:
Annual Allowance Tax relief

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