Pensions


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The Importance of GROSS PERSONAL PENSION CONTRIBUTIONS

When an individual makes GROSS PERSONAL PENSION CONTRIBUTIONS it has 2 immediate effects:

  • It will LOWER ADJUSTED NET INCOME which is used to calculate any RESTRICTION of the PERSONAL ALLOWANCE. (ADJUSTED NET INCOME = NET INCOME – GROSS PERSONAL PENSION CONTRIBUTIONS – GROSS GIFT AID PAYMENTS).
  • The GROSS PERSONAL PENSION CONTRIBUTION will INCREASE the BASIC RATE & HIGHER RATE TAX BANDS by the gross amount of the personal pension contribution.

What is the LIFETIME ALLOWANCE for pensions savings?

If you have a pension, at some stage you will want to make use of the money you have saved.

The good news is that once you reach pension age, the UK Government allows you take out a portion of your pension as a tax-free lump-sum payment. But there is a lifetime allowance, currently set at £1,073,100 for tax year 2020/2021, that is worth understanding.

The maximum tax-free lump-sum is calculated as the lower of;

  • 25% of the amount of your pension fund, or
  • 25% of the lifetime allowance, ie £268,250 (25% * £1,073,100)

For example, if your total pension is valued at £750,000, then your maximum tax free lump sum would be £187,500 (£750,000 * 25%), as this is lower than £268,250 (25% * £1,073,100).

If however, your pension is valued at £1,600,000, then your maximum tax free lump sum would be £268,250 (25% * £1,073,100) since this is lower than £400,000 (25% * £1,600,000).

The balance of your pension, up to your lifetime allowance of £1,073,100, then gets treated as taxable income on withdrawal from the pension and will get taxed at either 20% (basic rate), 40% (higher rate) or 45% (additional rate) depending on your particular circumstance.

In the case of a pension valued at £750,000, £187,500 can be withdrawn tax free and the balance of £562,500 would be treated as taxable income, depending on your personal tax circumstances.

In the case of a pension valued at £1,600,000, then £268,250 can be withdrawn tax free and the balance up to lifetime allowance, ie £1,073,100 – £268,250 = £804,850 will get treated as taxable income, depending on your personal tax circumstances.

Any amount over £1,073,100, is known as excess, and will then incur a lifetime allowance charge.

How does the LIFETIME ALLOWANCE CHARGE work?

The lifetime allowance charge will depend on how you withdraw the excess.

If you withdraw the excess as a cash lump sum, you will incur a 55% lifetime allowance charge. In the example of the £1,600,000 pension fund. This would mean that the excess, £1,600,000 – £1,073,100 = £526,900 would attract a charge of £289,795 (£526,900 * 55%) which the pension administrator would withhold and pay over to HMRC. You would then be paid a cash lump sum of £237,105 (£526,900 * 45%) which would then be subject to income tax in the normal way.

If however, you withdraw the excess of your pension to buy an annuity, then the lifetime allowance charge is 25%. And the income received from the annuity is subject to income tax as usual.

It’s important to understand the lifetime allowance so that you can plan the most tax efficient way to withdraw your pension.


What are RELEVANT EARNINGS?

The UK Government offers tax relief for pension contributions to encourage individuals to save for their later years.

An individual can contribute as much as they want into their pension(s) but the Government only allows tax relief on those contributions up to a maximum amount each year.

That maximum amount each tax year on which an individual’s gross contributions is allowed tax relief is the higher of;

  • £3,600, or
  • 100% of an individual’s ‘relevant earnings’

RELEVANT EARNINGS are defined as: TRADING PROFITS + EMPLOYMENT INCOME + FURNISHED HOLIDAY ACCOMMODATION INCOME.

What is the ANNUAL ALLOWANCE?

As we have seen above, tax relief for pension contributions made by an individual is restricted to a maximum amount each year which depends on an individuals relevant earnings.

But if all gross contributions made by an individual AND their employer, in a tax year, on which tax relief has been received, exceeds an individual’s ‘annual allowance’ of £40,000. Then a tax charge, known as an annual allowance charge, is payable to HMRC.

Can unused annual allowances be carried forward?

Yes they can, but only if an individual was a member of a registered pension scheme in that tax year. If this is the case, then any unused annual allowances can be carried forward from the PREVIOUS THREE TAX YEARS, on a FIFO basis (First In First Out).

This means that for the tax year 2020/2021, the annual allowance for this year is used first, then any unused annual allowance from tax year 2017/2018, from 2018/2019 and finally from 2019/2020, in this order.

Is the annual allowance RESTRICTED for high earners?

Yes, if an individual’s THRESHOLD INCOME exceeds £200,000 AND their ADJUSTED INCOME exceeds £240,000 then a restriction of the £40,000 annual allowance kicks in.

Let’s look at each of these limits in turn.

THRESHOLD INCOME = NET INCOME – GROSS PERSONAL PENSION CONTRIBUTIONS.

As mentioned, if THRESHOLD INCOME is more than £200,000 THEN we need to calculate ADJUSTED INCOME. If however, THRESHOLD INCOME is less than £200,000 then there is NO restriction to the ANNUAL ALLOWANCE .

ADJUSTED INCOME = NET INCOME + EMPLOYEE’S OCCUPATIONAL PENSION CONTRIBUTIONS + EMPLOYER’S OCCUPATIONAL PENSION CONTRIBUTIONS + EMPLOYER’S CONTRIBUTIONS INTO AN INDIVIDUALS PERSONAL PENSION SCEME.

This looks horrible to understand but can be thought of as follows;

For the SELF-EMPLOYED, ADJUSTED INCOME is simply NET INCOME.

But for the EMPLOYED, ADJUSTED INCOME is NET INCOME plus all pension contributions except their own contributions to personal pension schemes.

As mentioned, if ADJUSTED INCOME exceeds £240,000 then the ANNUAL ALLOWANCE is reduced by;

(ADJUSTED INCOME – £240,000) * 50%

The maximum annual allowance restriction is £36,000, so, when an individual’s ADJUSTED INCOME exceeds £312,000, then the maximum annual allowance restriction will apply and the individual’s ANNUAL ALLOWANCE will be reduced by £36,000 ((£312,000 – £240,000) * 50% = £36,000) from £40,000 to £4,000, for that tax year.

WARNING! ADJUSTED INCOME should not be confused with ADJUSTED NET INCOME which is used to calculate any restriction of an individual’s PERSONAL ALLOWANCE.

How is the ANNUAL ALLOWANCE CHARGE calculated?

When the amount of all contributions into pension schemes, on which tax relief has been obtained, exceeds the annual allowance for the years (including any unused annual allowance brought forward) then that excess is added into an individuals income tax calculation as the ‘top slice’ of income and charged to income tax, depending on the individual’s personal tax circumstances. It is taxed last, at Non Savings Income tax rates.