From 6 April 2016, individuals who have taxable income greater than £150,000 will have their annual allowance for that year restricted. The standard £40,000 allowance level will reduce by £1 for every £2 of income over £150,000. The maximum reduction will be £30,000, so an individual with taxable income of £210,000 or more will have an annual allowance of £10,000. Two tests are used to determine if the annual allowance is to be reduced – adjusted income and threshold income.
Adjusted income broadly means the total taxable income from all sources, plus the value of any employer pension contributions.
James earns £140,000 and has employer pension contributions of 10% (£14,000) in the 2016/17 tax year so will have an adjusted income of £154,000. This is £4,000 over the £150,000 cap that will reduce the annual allowance by £2,000, from £40,000 to £38,000.
In this case, the employer contributions remain within the tapered annual allowance.
Should James also receive a bonus payment of £54,000 during the 2016/17 tax year, the adjusted income would be re-calculated to £208,000. This is £58,000 over the £150,000 cap which will reduce his annual allowance by £29,000, from £40,000 to £11,000.
In this case, the pension contributions of £14,000 are over the tapered annual allowance of £11,000 and if carry forward is not available then an annual allowance tax charge is required to be paid (in this instance at the full rate of 45%, thus totalling £1,350).
To ensure pension savings over £40,000 (using carry forward) do not affect lower paid workers, a second income definition is used – threshold income.
This test considers total taxable income less gross pension contributions paid under the relief at source system. Any individual with threshold income under £110,000 is able to retain the full £40,000 annual allowance.
Lisa draws an income of £105,000 in the 2016/17 tax year. Her business had a successful year and using available carry forward an employer pension contribution of £60,000 is made. The adjusted income would be calculated as £165,000 which would normally reduce her annual allowance by £7,500, from £40,000 to £32,500.
However, the threshold income calculation can deduct the £60,000 pension contribution from the adjusted income calculation, resulting in a threshold income of £105,000 which is below the £110,000 limit. This allows for the full £40,000 annual allowance to be retained.
The ability to carry forward three years of unused allowance will remain unaffected, will not be subject to post-dated tapering and, therefore, is a valuable pension contribution tool. Once carry forward is exhausted, consideration for alternative investment vehicles may be required.