Since 2016/17, the ‘headline’ annual allowance has been £40,000. However, the annual allowance will reduce by £1 for every £2 of adjusted income that an individual has in excess of £150,000. The maximum reduction is £30,000, so anyone with an adjusted income of £210,000 or more will have an annual allowance of £10,000. This test will be applied annually on a tax year basis with the resulting reduced annual allowance rounded down to the nearest pound.
To ensure that this measure is focused on high earners those with threshold income of £110,000 or less will not be subject to the tapered annual allowance.
This means that the tapered annual allowance applies to an individual when:
- their threshold income for the tax year is more than £110,000; and
- their adjusted income for the tax year is more than £150,000.
Establishing Threshold Income
The starting point is to establish the individual’s ‘net income’ i.e. their gross taxable income from all sources less any allowable deductions.
An individual’s gross taxable income from all sources could include any of the following:
- earnings from employment including benefits in kind;
- earnings from self-employment or partnerships;
- most pension income (i.e. State Pensions, scheme pensions, lifetime annuity, income drawn from a drawdown plan, UFPLS payments etc);
- interest on most savings;
- income from shares (dividend income);
- rental income; and
- income received from a trust.
Allowable deductions can be found in section 24 of the Income Tax Act 2007 and would include various types of loss relief, deductible interest payments, and gifts to charities.
Having worked out the ‘net income’
- Deduct the grossed up amount of any pension contribution (made by anyone other than the individual’s employer) subject to relief at source i.e. into a stakeholder pension, personal pension or a SIPP. Contributions paid by the employer should not be deducted.
- Add any employment income given up via salary sacrifice via an arrangement set-up on or after 9 July 2015.
- Deduct any lump sum death benefits taxed as the recipient’s income. These are lump-sum death benefits that arise where the holder of the pension fund paying them dies aged 75 or older, or pre-75 and they are paid outside of the two-year window following the member’s death.
Where the member pays their pension contribution via the net pay method (i.e. into an occupational money purchase scheme or an occupational defined benefit scheme), the contribution was taken into account when arriving at their gross taxable income and so does not have to be deducted again.
Establishing Adjusted Income
Adjusted income is the ‘net income’ (gross taxable income from all sources less any allowable deductions) that we already established when calculating our threshold income,
- Plus any employer contributions.
- Plus any employee contributions paid under the net pay method.
- Minus any lump sum death benefits taxed as the recipient’s income (see above).
When working out the employer contributions, for defined contribution schemes you just add back the monetary amount. However, for defined benefit schemes it’s a little more complicated because you have to take the accrual figure and deduct the employee contributions (not AVCs) to arrive at the employer contribution.
The tapered annual allowance may be supplemented by any unused annual allowance carried forward from previous years. However, the amount of unused annual allowance available when carrying forward from a year where the taper has been applied will be the unused balance of the tapered amount for that year.
The Money Purchase Annual Allowance
Individuals who have flexibly accessed their pension savings will continue to have a money purchase annual allowance of £4,000. But where this applies, the annual allowance or alternative annual allowance, against which their defined benefit savings are tested, will be restricted by the same taper. In other words, if contributions were subject to the taper then any amount available to carry forward is the amount as measured against the tapered allowance.
The tapered annual allowance excess is added to the employee’s other income and taxed at their marginal rate, so in many cases this will be 45%. The employee can just pay it directly themselves via their self-assessment tax return, or it may be possible to use the scheme pays option depending on how they exceeded their annual allowance and if the scheme is able to provide this. Where the ‘scheme pays’ option is available it is often the favoured option in view of the charge being paid from untaxed monies. However, schemes are only obliged to pay the charge where requested to do so and the annual allowance charge is at least £2,000 and the total pension input into that scheme is more than the standard annual allowance for the year. So it is possible that employees subject to the tapered annual allowance won’t automatically qualify for the scheme pays option and will have to pay the charge from their own funds.