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Tapered annual allowance: planning ideas and potential pitfalls

Author Image The Technical Team
9 minutes read
Last updated on 6th Apr 2019

Overview

Discover how the tapered annual allowance works, and the related planning issues. 

Key points

  • Both the threshold and adjusted income limits have to be breached for the Tapered Annual Allowance to apply.

  • Once the taper has been calculated, you will need to recalculate this if any further pension planning is to be done.

Two conditions

Much has been publicised about how to calculate the Tapered Annual Allowance (TAA). Are you aware that any subsequent planning could affect the taper calculations?

In our article Tapered annual allowance we detail how the tapered annual allowance works as per legislation since its introduction on 6 April 2016. In this article we provide a brief overview of this and a case study to highlight the potential pitfalls that high earners can face if the TAA is triggered.

In short there are two conditions before the taper applies, you must exceed threshold income of £110,000 and have adjusted income (not to be confused with adjusted net income) of over £150,000.

Threshold Income Adjusted Income

Total Income

This is the total income subject to income tax, it includes the full value (non-top-sliced) of bond gains, dividend income, bank interest etc. It’s important to remember to deduct contribution to a net pay pension arrangement from any salary. 

Total Income

This is the total income subject to income tax, it includes the full value (non-top-sliced) of bond gains, dividend income, bank interest etc. It’s important to remember to deduct contribution to a net pay pension arrangement from any salary. 

Less Less

Allowable Reliefs

These are the allowable reliefs under the income tax act of 2007. This includes such things as early trade losses relief, share loss relief but this does NOT include the personal allowance as a deduction.

Allowable Reliefs

These are the allowable reliefs under the income tax act of 2007. This includes such things as early trade losses relief, share loss relief but this does NOT include the personal allowance as a deduction.

Less Plus

Personal Pension Contributions to a relief at source scheme

The gross amount of any relief at source pension contribution made by the member, or a third party on their behalf.

Paid Gross pension contributions

This includes S226 Retirement Annuity Contracts, personal contributions under a net pay scheme (including DB contributions), contributions gaining UK tax relief but made to overseas pension schemes, using excess relief under net pay provisions, and using relief on making a claim provisions

Plus Plus

Employment income given up

This is any salary sacrifice for pension savings set up on or after 9 July 2015, pre-existing arrangements do not have to be added in.

The value of Employer(s) pension contributions

For Money Purchase schemes this is simply the value of contributions made by the employer.

For Defined Benefit scheme this is the Pension Input Amount minus member contributions (as these are taken care of in the step above, so not removing these would double count them).

Less Less

Taxable Lump Sum Pension Death Benefits

This is mainly if you receive a lump sum from a deceased pension member’s fund when they died over 75 (although this can be under 75 in some circumstances). Any taxable income has to be added in to the total income.

Taxable Lump Sum Pension Death Benefits

This is mainly if you receive a lump sum from a deceased pension member’s fund when they died over 75 (although this can be under 75 in some circumstances). Any taxable income has to be added in to the total income.

To trigger the taper you must exceed the 2 tests that are carried out, if you don’t exceed one then there is no need to worry about the other calculation. Although you may wish to use our Annual Allowance calculator as this will simultaneously do the calculations for you and determine the level of tapering that applies.

Whilst this covers how to calculate the taper, the impact on planning can be huge. This is covered in the case study below, highlighting the danger that this taper can have on planning.

Case study

Let’s look at a case study to illustrate this issue. This is based on UK tax rates*. Peter, a higher earner in the current tax year but, he was not affected by the taper for any earlier tax year, has asked his adviser to calculate if he might be affected by the tapered annual allowance for the year. The calculations will include any planned contributions from Peter and his employer (Peter is in a net pay scheme). He has no available carry forward.

*Scottish taxpayers will pay the Scottish rate of income tax (SRIT) on non-savings and non-dividend (NSND) income. NSND income includes employment income, profits from self-employment (including sole trades and partnerships), rental profits, and pension income (including the state pension). Similarly, from 6 April 2019 Welsh Taxpayers will pay the Welsh Rate of Income Tax (CRIT (C for Cymru)) on NSND income.  

Other tax and deductions such as Corporation Tax, dividends, savings income and National Insurance Contributions etc. will remain based on UK rules. This could mean the amount of income tax relief which can be claimed on pension contributions by Scottish and UK tax payers may not be the same. For more info on SRIT and how this works in practice, please visit our facts page. For more info on CRIT and how this works in practice, please visit our facts page.

The adviser works out that Peter has a tapered AA. To break this down Peter has a threshold income of £165,000 (which is also his current taxable salary) and adjusted income of £180,000 (he pays £5,000 under net pay and his employer contributes £10,000). As a result his tapered AA is £25,000. As the tapered AA will reduce the full AA by £1 for each £2 over the adjusted income limit of £150,000 (as long as threshold income is also above £110,000) this means that Peter has £10,000 of AA left for the tax year.

It’s also important to remember that for those with adjusted income over £210,000 that the minimum they will have for this year’s annual allowance will be £10,000.

At the end of the year Peter’s employer wishes to make a pension contribution for him of £10,000. Will this be a good idea for Peter?

No.

The new employer contribution is included in the taper calculation therefore this changes Peter’s adjusted income to £190,000. This then has a knock - on effect on his tapered AA, reducing this to £20,000. However, his total AA usage is now £25,000, so an excess of £5,000 exists. There is no carry forward available, therefore based on Peter’s tax rate this would result in a charge of £2,250.

Peter believes that this charge will be paid by his scheme as it fits the criteria for ‘mandatory scheme pays’ Is that correct?

No.

You can only call upon scheme pays if your tax charge is above £2,000 and your inputs to the scheme for the tax year are above £40,000. So mandatory scheme pays would not apply in Peter’s case.

Therefore Peter has had an extra £10,000 added to his pension, but this has cost him £2,250 from his own pocket. A cost of £2,250 to get £10,000 into a pension isn’t a bad rate of return, if we assume that he has to pay higher rate tax on the pension when he takes this extra £10,000 he will receive £7,000 (factoring in 25% tax free PCLS). Then the net benefit to Peter is £4,750.

But could there have been a better outcome for Peter?

A potential solution

Instead of making a pension contribution of £10,000, Peter could elect to take this extra cash from his employer as a bonus (this would have the effect of increasing his threshold income to £175,000). After deduction of income tax of 45 per cent, and National Insurance of 2 per cent, £5,300 net would be received. Of course paying this bonus would cost Peter’s employer £11,380 as they have to pay NI on top of this.

Peter could then make a £4,000 Relief at Source (RAS) contribution to a pension scheme, which is grossed up to £5,000. He would then be able to reclaim £1,250 additional tax relief in his tax return. If we again assume that he extracts this £5,000 from his pension at higher rate tax, he will receive £3,500. On the face of it this would appear to be less of a net benefit, but if you add on the tax reclaim this becomes £4,750, which appears to be identical to the employer making the contribution. But the cherry on top of this is that Peter still has £1,300 in the bank (the employer bonus payment netted Peter £5,300 and he only had to pay £4,000 to the RAS scheme), so his net wealth is now £6,050.

His adjusted income will remain at £190,000, so there is no further reduction in the tapered AA. This also has the effect of reducing his threshold income to £170,000.

So in this scenario Peter has fully used up his available tapered AA of £20,000.

Peter could of course have simply kept the £5,300 net and not funded anything to the pension. But in the above scenario he was prepared to ‘sacrifice’ the bonus he received to make a pension contribution. But of course every situation is different and it will depend on the individual and their own specific needs.

But what if in addition to the planning above, Peter had £60,000 of carry forward left? 

Does this mean that Peter could make a net payment to a RAS scheme of £48,000 and fully use up his AA and available carry forward?

No

Making a £60,000 gross contribution to a RAS scheme would bring his threshold income down to £110,000, therefore one of the two triggers for the tapered AA to apply has not been met. He has regained the full £40,000 for this year. So another £20,000 gross can be made to a pension scheme. Ironically, as he is below the threshold income level this contribution can be made by his employer!

Summary

The tapered AA calculations are complicated enough, but when this is coupled with planning it is almost a circular equation to work out what further pension contributions can be made. You need to put the cart before the horse and after the horse to know what the final impact will be. But it is vital to be aware that changes to any part of the calculation can affect what can be paid.

Early in the tax year it may be very difficult to tell what the client’s final position will be. Pay-rises, promotions, employee and employer contributions will all affect the tapered AA.

Given the variables, is aiming to use up a client’s AA and carry forward early in a tax year a good idea? Or would it be better to let the known fixed contributions continue (providing that this won't exceed the tapered limit) and plan for this at the end of the year when the potential variables will be lessened?

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