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Tapered annual allowance & high earners

From 6 April 2020 the annual allowance taper figures will be adjusted to give a higher threshold level. The tapered annual allowance calculations will now not affect anyone with a Threshold Income level below £200,000. The taper will now start at £240,000 and be extended to a minimum of £4,000 annual allowance.

The tapered annual allowance was originally introduced from 6 April 2016 - when it was stated the annual allowance would be potentially tapered to a minimum of £10,000 for those with adjusted income exceeding £150,000.

The aim here was to reduce the level of pension funding high earners and their employers can make into pension schemes going forward. In this way HMRC are also restricting the high level of pension scheme tax relief they are liable for, either to the individual or the company.

If they exceed these threshold and adjusted income amounts, their annual allowance may be reduced by £1 for every £2 of adjusted income over this level until the minimum annual allowance level of £4,000 is reached.

Detail

Threshold income

The idea of the threshold level of income (set at £200,000 for the current tax year) is to ensure that there is some form of certainty for individuals in terms of levels of income and who may be affected, and to ensure this rule does not impact people who have large one off employer funded pension contributions.

Threshold income is comprised of;

  • Net income, which is made up (but not exclusively) of:

            - income from employment (including any benefits)

            - profits from self-employment

            - taxable social security benefits

            - pensions (including the State Pension)

            - savings, dividend and rental income.

Net income is defined fully within step 2 of the calculation in section 23 of Income Tax Act 2007. Visit www.legislation.gov.uk for more information.

When calculating net income for tapered annual allowance calculations, you will always deduct personal contributions paid by the net pay arrangement.

  • Plus any income given up by salary sacrifice arrangements entered into post 8 July 2015.
  • Minus any personal pension contributions made via the relief at source method (i.e. personal contributions paid net and grossed up by basic rate tax within the pension scheme). This will be a personal pension scheme contribution.
  • Minus some allowances (such as tax relief after making a gross RAC contribution) and taxable death benefit lump sums.

If the calculated threshold income is below this level (£200,000 for the current tax year), no further tests need to be carried out and the client can continue to contribute up to the standard annual allowance of £40,000 (current tax year) unless restricted by the Money Purchase Annual Allowance. If however, after this calculation the income level is in excess of £200,000 the member will have to undertake the adjusted income test.

Adjusted income

This test is to determine the actual income amount which will be used to determine the appropriate level of annual allowance that a member may use. The income level that triggers the tapering annual allowance is £240,000. This income level has been “adjusted“ to take into consideration employee contributions taken from gross pay under the net pay arrangement, employer contributions and salary/bonus sacrifice.

Again there are several factors to take into consideration to determine the level of adjusted income. The calculation is;

  •  Net income, which is made up (but not exclusively) of;   

             - income from employment (including any company benefits)

             - profits from self-employment

             - taxable social security benefits

             - pensions (including the State Pension)

             - savings, dividend and rental income

Net income is defined fully within step 2 of the calculation in section 23 of Income Tax Act 2007. Visit www.legislation.gov.uk for more information.

When calculating net income for tapered annual allowance calculations, you will always deduct personal contributions paid by the net pay arrangement.

  • Plus any claim for excess relief (where the amount of a contribution paid by an individual under a net pay arrangement exceeds the employment income from the individual’s employment or it is not possible for the employer for any other reason to deduct the whole amount of the contribution from the individual’s income – under these circumstances the individual would need to make a stand alone claim for the excess tax relief).
  • Plus any individual contributions made by the net pay arrangement (i.e. where contributions are made via payroll deduction before income tax is paid, therefore giving immediate tax relief). This will be an occupational pension scheme contribution.
  • Plus any UK tax relieved overseas pension contributions.
  • Plus employer pension contributions.
  • Minus any lump sum death benefit the individual accrues from another person’s death that is taxable (e.g. benefits on death after the age of 75).
  • Minus some allowances (such as tax relief after making a gross RAC contribution) and taxable death benefit lump sums.

In all calculations HMRC have removed the effectiveness of salary and bonus sacrifice to reduce an individual’s level of income. The purpose of this was to prevent employers and employees artificially reducing the level of income they are deemed to have earned to pass the threshold income test and not have to undergo the adjusted income test to see if they will have their annual allowance reduced. Salary/bonus sacrifice is specifically added back in for threshold income calculations although not mentioned at all within the adjusted income calculations. This is because as part of the adjusted income calculation, all pension contributions, including those employer contributions funded by salary sacrifice, are included.

You will note that the calculations for both threshold income and adjusted income take into consideration pension contributions in different ways. By removing relief at source contributions from the threshold income calculation the total income level is reduced down to account for those individuals who have net pay contributions and give a lower salary to be considered. By contrast, should the individual fail the threshold test and have to apply the adjusted income test, the calculation is less favourable. Previously the relief at source contribution has been removed to reduce down the level of calculated income, however, here the calculation adds in the net pay contributions and so effectively raises the calculated income.

Example for threshold income

Individual earns £225,000 and via relief at source arrangement pays £30,000. This amount would be removed from the individual’s income to give a figure of £195,000.

Example for adjusted income

Individual earns £225,000 and via net pay arrangement pays £30,000. This amount would be added to the individual’s income to give a figure of £255,000.

It is also worth noting that the net income part of the calculations for both the threshold and adjusted income calculations will not include any bond withdrawals that are within the available 5% allowances and will not include collective investment disposals creating a capital gains tax liability. However, any interest and dividends accumulated within a collective will be counted as net income. Also any chargeable gains triggered within a bond will be counted as net income. This will be the full amount of the gain and not a top-sliced gain (for example where applying top-slicing between higher rate and additional rate tax).

If an individual’s annual allowance is reduced due to the adjusted income calculation, it must be remembered that any excess over their lower annual allowance will be subject to the standard annual allowance excess charge. By definition, by suffering the tapered annual allowance the individual will be a high earner and as the annual allowance excess charge is based on the marginal rate of tax, this tax liability is likely to be 45% of the excess amount.

Carry forward

These new tapered annual allowance rules came into effect from 6 April 2016 and will be calculated and applied each year. This may mean that an individual may have different annual allowance levels each year depending on their income for that year. In terms of carry forward, the new annual allowance figures will not have an effect on any other year. This will mean that an individual who is looking to carry forward into 2020/21 tax year may have a restricted annual allowance applied for tax year 2020/21 but will still have the full annual allowance available for the previous years.

As an example, for someone who:

  • is subject to the maximum tapered annual allowance of £4,000 for tax year 2020/21 and
  • has been a member of a registered pension scheme for the previous three years but
  • has made no pension contributions.

They will be able to fully fund the current tax year to £4,000 and then carry forward unused annual allowance of potentially up to £40,000 from tax years 2017/18, 2018/19 and 2019/20 (subject to taper rules if applicable).

Please note. The tapered annual allowance calculation will only apply to that specific year. This means that you may have to do this calculation for multiple years. The new levels for threshold and adjusted income are applicable for tax year 2020/21 onwards and the old levels are applicable for previous tax years 2016/17 – 2019/20.

Here is a link to simple examples to explain some of the different situations and how the client may be affected: 

Tapered annual allowance examples

 

Updated June 2020

For financial advisers only. Not to be relied on by consumers.


 

 

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