The annual cap is being reduced for high earners. Here's how investors can protect themselves while maximising contributions.
Annual pension contributions have become something of a tax minefield, particularly for those with an income above £150,000, who face new restrictions on how much they can save into their pensions. Most people are allowed to pay up to £40,000 into a pension each year and receive generous tax relief, ranging from 20 to 45 per cent depending on their income – but new legislation for the tax year 2016/17 slashed this annual allowance for the UK’s highest earners.
New taper system
A new taper system has been introduced which reduces your £40,000 contribution allowance by £1 for every £2 of income above £150,000, with a maximum reduction of £30,000; so anyone earning more than £210,000 can only pay £10,000 into a pension each year. The system is fiendishly complicated, however, and it is easy to inadvertently contribute more than you are allowed. Moreover, those on lower wages of around £110,000 can also be hit.
To work out whether the new rule affects you, you need to calculate your income by two measures: so-called threshold income and adjusted income. First you need to work out the threshold income, which includes all income, not just your salary but investments and buy-to-let properties, for example. You must count in benefits in kind from your employer such as medical insurance, and any income given up in an employer’s salary sacrifice arrangement, if it was set up by after 8 July 2015.
If your threshold income is less than £110,000, then the good news is that your annual contribution allowance of £40,000 is not affected. If it is above, however, you will need to calculate your adjusted income, which is your threshold income plus any pension contributions you have made in the year, including any employer contributions made on your behalf. If your adjusted income is more than £150,000 a year, you will be caught by the new taper rule.
Various problems stem from people having multiple sources of income. Many people do not know for certain what their annual income will be until the very end of the financial year – particularly if, for instance, they are self-employed or receive an end of year bonus.
If you do exceed the limits, HMRC imposes a charge at your marginal rate of income tax on the excess contributed. This means those earning more than £210,000 who inadvertently paid £40,000 into their pension last year could face a tax bill of £13,500, equivalent to 45 per cent tax on the excess £30,000. Around 350,000 people had a total income of more than £150,000 in the 2014/15 tax year, according to the latest government data, and unfortunately many will be caught with a nasty retrospective tax bill.
Calculating the value of contributions made by an employer to your workplace pension scheme can be particularly complicated. For a money purchase (DC) scheme it is simply the value of the contributions paid during the period, but for salary-related (DB) schemes it is a more challenging task, requiring you to work out the increase in the value of your pension benefits over the year by calculating the value of your rights at the beginning of the year and comparing them with the value of your rights at the end of the year (see box). You can apply to your pension scheme for this figure, but it is unlikely to be available until the end of the tax year.
One step you can take to boost your pension contribution is the use of ‘carry forward’, where you claw back any leftover allowance from the previous three tax years. Your employer’s HR department should be able to help. However your employer will not be privy to information about your income from other sources, and it’s each individual’s responsibility to calculate their own annual allowance.
There are also investments that offer an income tax credit of 30 per cent against your income tax liability in the tax year the investment was made. For example, you can subscribe to venture capital trusts (VCTs), which are stock market-listed funds that invest in early-stage companies. The tax credit is offered by the government to reward your support for higher-risk young entrepreneurial companies that could make up the backbone of UK plc in future. But the 30 per cent tax break is only available if you invest in new share offers, and you must hold the shares for at least five years.
This tax break is attractive: it means for example that if you put in £20,000, you would receive an income tax credit of 30 per cent, or £6,000. If your initial VCT investment does not make a loss after five years, you will have effectively turned a net outlay of 70p into 100p, which is equivalent to a 43 per cent return tax-free. The better VCTs have delivered good returns on top of the tax reliefs, but management charges may be as high as 5 per cent.
VCTs were traditionally considered highrisk, but in fact the number of firms operating in this sector has been shaken out. The big players such as Octopus Titan, Mobeus, Baronsmead and Northern are experienced firms with access to useful skills and a hands-on approach, typically appointing a chairman to the fledging company and taking a seat on the board.
Enterprise investment schemes
Similarly, enterprise investment schemes offer a 30 per cent tax credit for individuals who subscribe in cash for newly issued full-risk ordinary shares in a qualifying company, or EIS fund. As EIS tend to be illiquid, the government is super generous and only requires you to hold them for three years to keep the tax credit. Gains from both VCTs and EISs are also tax-free.
Looking ahead, if your employer has been making hefty contributions to a pension scheme on your behalf, you could ask them to pay you the equivalent sum in some other way, typically as additional salary, to ensure you comply with the allowance limit in future years. Even better might be to persuade them to divert it into a corporate Isa where you will at least gain the tax break when you make withdrawals, and will possibly benefit from corporate fee discounts. There are other rules concerning your pension contribution limit that it is easy to overlook. Critically, the money purchase annual allowance (MPAA) has been reduced from £10,000 to £4,000 a year for anyone who has accessed their pension pot under the pension freedom rules introduced in 2015. ‘Carry forward’ is also prohibited in these cases.
The definition of ‘withdrawing’ your pension under the new freedoms is complicated, however. What matters is the level of flexibility you have left open for yourself. For example, the MPAA is not reduced if the pension has been taken in the form of a traditional non-flexible lifetime annuity, nor if you have taken small pension benefits where the whole pot is worth £10,000 or less, nor if you have moved to flexi-access drawdown but only taken the tax-free quota and no taxable income. Similarly if you are making withdrawals under a ‘capped drawdown’ plan set up before the freedoms were introduced, your limit remains at £40,000. Benefits from someone else’s unused pension are also ignored for these purposes.
If you are subject to the MPAA as well as tapering and can use ‘carry back’ from previous years, then the maximum amount of defined benefit pension savings that qualify for tax relief will be the standard annual allowance of £40,000 less the MPAA of £4,000, or £36,000.
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