Pensions are one of the most tax-efficient ways that you can save for the future.
You benefit from tax relief of at least 20% on your contributions – meaning that a £1,000 contribution only “costs” £800. If you’re a higher- or additional-rate taxpayer, you can then claim additional relief through your self-assessment.
While the tax relief offers an incentive for individuals to make their own retirement provision, the cost to the Exchequer is significant. Indeed, PensionsAge reports that the total cost of pensions tax relief passed an eye-watering £50 billion for the first time in 2021/22.
To limit the tax relief available – particularly for higher earners – the government restricts the amount of tax-efficient pension saving you can make in a tax year.
While the chancellor increased these limits in his 2023 Spring Budget, Professional Adviser reports that the number of people being caught by additional tax charges for breaching these limits has risen sharply.
Read on to find out why you could be affected by these tax charges, and what you need to know to ensure you don’t get caught out.
Individuals pay more than £1 billion in pension tax charges
The latest figures reported by Professional Adviser show that excess contributions – namely those on which a tax charge would usually be levied – rose from £814 million to a record £1.2 billion in 2020/21. The number of individuals affected rose from 43,870 to 53,330.
In addition, those individuals who use a “scheme pays” option (normally where a defined benefit (DB) scheme pays the tax charge in return for a lower pension) saw their charges rise from £202 million to £335 million.
Commenting on these figures, former pensions minister, Steve Webb, said: “The figures show that our highly complex tax system in 2021/22 was catching an increasing number of people out as […] charges soared.
“This would have likely been even more pronounced in future data sets due to the various frozen allowances had Hunt not made considerable changes to the pension landscape in the Spring Budget.”
How the Annual Allowance works
The Annual Allowance restricts the amount of tax-efficient pension contributions you can make each year before additional tax charges are levied. In 2023/24 it stands at £60,000 – up from £40,000 in the previous tax year – or 100% of your earnings, whichever is lower.
For a “defined contribution” scheme, contributions are defined as:
- Your own contributions, plus any tax relief you receive
- Any employer contributions
- Any contributions made on your behalf by someone else.
For DB pensions, the calculation is based on the capital value of the increase in your pension benefits over the tax year.
If the total contributions in a tax year exceed the Annual Allowance, you could pay additional tax charges.
To further complicate the rules, there are some instances where your Annual Allowance may be lower than £60,000. If you’re not aware of whether these rules apply to you, you could end up being caught out with a tax charge.
Why your Annual Allowance may be lower
You are a higher earner
To further restrict the tax relief available to higher earners, your Annual Allowance tapers if:
- Your “threshold income” (your net adjusted income minus pension contributions) is above £200,000, and
- Your “adjusted income” (your threshold income plus any pension or company pension contributions) is above £260,000.
In this case, you lose £1 of your Annual Allowance for every £2 of adjusted income over £260,000, to a minimum of £10,000. If your adjusted income is more than £360,000, your Annual Allowance will be just £10,000 – meaning you can only make pension contributions up to this amount before a tax charge applies.
Complications around the taper have been one of the most common reasons why many individuals – including a significant number of NHS workers – have faced additional pension tax charges.
You have already started to draw from your defined contribution pension
Increasingly, retirees are choosing a “phased retirement” where they remain in work in a reduced capacity while supplementing their income from their pension.
If you’ve already started to flexibly access your defined contribution (DC) pension, and you want to consider topping up your fund based on your earnings, the Money Purchase Annual Allowance restricts your tax-efficient contributions to £10,000.
Be careful of paying additional tax charges
If you are a high earner, you are subject to the Money Purchase Annual Allowance, or you simply want to make a sizeable pension contribution (without using “carry forward”) you could face a tax charge.
Tens of thousands of taxpayers are facing this issue every year – although the increase to the various Annual Allowances announced in the 2023 Spring Budget will be welcome to anyone facing these concerns.
A note about the Lifetime Allowance
Before the 2023/24 tax year, the Lifetime Allowance (LTA) restricted the amount of tax-efficient pension contributions you could accumulate over your lifetime. The LTA was £1,073,100.
Had the value of your fund(s) exceeded this limit, you could have faced an additional tax charge of 55% if you drew the excess as a lump sum, and 25% if you drew it as income.
In the 2023 Spring Budget, the chancellor announced he was removing the LTA tax charge, and pledged to abolish the LTA altogether in a future piece of legislation.
The benefit to you is that there is now no limit as to the total size of the pension fund you can build up tax-efficiently.
Get in touch
If you want to maximise your tax-efficient pension contributions, we can help you to make sure you don’t fall foul of these complex rules.
To find out more, please get in touch. Email hello@sovereign-ifa.co.uk or call us on 01454 416653.
Please note
This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future results.
The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates and tax legislation may change in subsequent Finance Acts.
The Financial Conduct Authority does not regulate estate planning, tax planning or will writing.
