As we move into the final month of the 2019/2020 tax year it is worth reminding ourselves to use up pension allowances and reliefs. Here we remind you of some of the traditional approaches.
Utilize the annual allowance
Despite recent cuts to the annual and lifetime allowances, pension funding is still incentivised by generous tax benefits. Tax relief against personal contributions and equivalent benefits for employer contributions represent an exemption from income tax on the segment of earnings that are directed to retirement funds. This is a significant benefit and should be fully utilised within the one’s financial means.
Each tax year, total personal contributions above £3,600 gross are restricted to relevant UK earnings; and total contributions (including accrual of defined benefits) from all sources are restricted by the standard or tapered annual allowance plus carry forward. If you have triggered the money purchase annual allowance and are therefore further restricted to total money purchase contributions of £4,000 each tax year without carry forward, you can use the remaining allowance to accrue within any defined benefit schemes.
Planning
Within the limits of affordability (and assuming the money purchase annual allowance doesn’t apply), you should top up your money purchase contributions to the lower of:
the remainder of your unused relevant UK earnings
the remaining annual allowance plus carry forward.
EXAMPLE
Adam earns £120,000 in 2019/2020. He has already paid £5,000 and benefited from matched employer contributions. He is not subject to the tapered or money purchase annual allowances and has £25,000 carry forward available from 2016/2017 to 2018/2019.
His maximum tax-relievable personal contribution is the lower of:
unused relevant UK earnings: £120,000 – £5,000 = £115,000
unused annual allowances: £40,000 – £10,000 + £25,000 = £55,000
If he can afford the contribution, Adam should pay £55,000 gross (£44,000 net) to his money purchase pension before the end of the tax year in line with the provider’s end of tax year requirements.
He will get 20% tax relief at source – £11,000; a further £11,000 higher rate tax relief provided that he submits a self-assessment tax return for the tax year detailing the contribution. Furthermore, he will reclaim the remaining £7,500 of his income tax personal allowance, reducing his tax bill by a further £3,000.
His effective rate of tax relief will be 45.5%.
Carry forward
In the above example, it was necessary to work out the unused annual allowances for carry forward purposes. This allowed the unused allowances from the three previous tax years to be brought forward and added to this year’s allowance.
For those who can pay contributions above their annual allowance for the year (including those paid by their employer), carry forward is an integral part of tax year end planning. The rules are straight forward:
The unused annual allowance (standard or tapered) of each of the last three tax years is carried forward and added to this year’s allowance.
Carry forward from a particular tax year is only available if the client was a member of a registered pension scheme in that year.
The current year’s allowance is used first, then the allowance of the earliest available carry forward years, then the next earliest year and so on.
The rules for the 2015/2016 tax year, which can still be relevant, are different and are explained in our CPD Guide: The Tax Aspects of Pension Funding.
No formal application is required, but if the annual allowance plus carry forward is exceeded the excess needs to be noted on the supplementary self-assessment form.
Earnings are not carried forward, so a scheme member still needs relevant UK earnings to justify personal contributions. Employer contributions, however, are not limited by earnings.
EXAMPLE
Fred is self-employed and earned £35,000 in his financial year ending in 2019/2020. He has paid no pension contributions yet this year but wants to pay a contribution of £50,000 utilising some of his unused allowances from 2016/2017 to 2018/2019.
Whilst Fred has unused annual allowances from the three previous tax years, carry forward is not relevant for him. His maximum tax-relievable personal contribution this tax year is £35,000 gross and he cannot receive employer contributions.
Despite recent cuts to the annual and lifetime allowances, pension funding is still incentivised by generous tax benefits.
Reclaiming the personal allowance and child benefit
As well as building up retirement benefits in a tax-efficient way, paying personal contributions to a pension can help reclaim the income tax personal allowance and avoid the high income child benefit charge. In both instances, the underlying income measure that makes this possible is ‘adjusted net income’, which is total taxable income before deducting the personal allowance less relief at source pension contributions and gift aid payments.
The relevant income band for the personal allowance is £100,000 to £125,000 in 2019/2020. Every £2 of adjusted net income above £100,000 reduces the personal allowance by £1. Therefore, as the personal allowance in 2019/2020 is £12,500, it is reduced to £0 when income exceeds £100,000 by at least £25,000 (2 x £12,500).
For child benefit, the relevant income band is £50,000 to £60,000. Every £100 of adjusted net income above £50,000 of the highest earner of a couple, one of whom receives child benefit, triggers a tax charge of 1% of the benefit received. Therefore, when income exceeds £60,000 the tax charge equals 100% of the benefit received, effectively withdrawing the benefit. If child benefit has not been claimed or received (perhaps because the couple knew one of their incomes would be too high) there is no tax charge.
EXAMPLE
Jude receives an annual salary of £120,000. In addition, he benefits from a 15% employer pension contribution of £18,000, which requires him to pay 5% or £6,000 gross.
His adjusted net income is
Income £120,000
Pension (£6,000)
ANI £114,000
Based on this he is set to lose £7,000 of his personal allowance.
If Jude can afford further contributions of £14,000 gross, he will reclaim his full personal allowance. The contribution will cost him £11,200 up front, but he will benefit from higher rate tax relief of £2,800 and an income tax reduction of £2,800 (owing to the increase in the personal allowance) when his self-assessment tax return has been submitted.
The contribution will ultimately cost him just £5,600, thus benefiting from 60% tax relief and within his annual allowance for 2019/2020.
EXAMPLE
Sadie, who receives child benefit for two children, receives an annual salary of £55,000. In addition, she benefits from a 5% employer pension contribution of £2,750, which requires her to pay in the same amount.
Her adjusted net income is:
Income £55,000
Pension (£2,750)
ANI £52,250
Her child benefit entitlement is £1,788.80 and her high income child benefit tax charge will be:
*£2,200/£100 = 22% x £1,788.80 = £393.53
(*every full £100 above £50,000 is included)
If Sadie can afford further contributions of £2,250 gross, she will avoid this tax charge. The contribution will cost her £1,800 initially, but she will benefit from higher rate tax relief of a further £450 and avoid a tax charge of £393.53.
The contribution will ultimately cost her £956.47, thus benefiting from 57.49% tax relief.
Source: Scottish Widows