Pensions are one of the most tax-efficient ways your clients can save for their future. However, in return for generous tax relief, particularly for higher- and additional-rate taxpayers, there are rules governing just how much a client can pay into their pension tax-efficiently every year.
As of the 2022/23 tax year, this Annual Allowance sits at £40,000, or 100% of a client’s earnings if lower. For some high earning clients, and those already flexibly drawing an income from their pension, the limit can be significantly lower.
In recent years, the number of breaching the Annual Allowance has risen significantly. Increasingly, your clients will be at risk of falling foul of the complex rules, and potentially incurring significant tax charges.
So, to help you, here’s why your clients may be facing Annual Allowance issues and what they can do to avoid punitive tax charges.
Individuals breaching the Annual Allowance pay more than £250 million in tax charges
A new House of Commons report, published by Money Marketing, has revealed that the number of individuals breaching the pension Annual Allowance has risen by more than 675% in five years.
The report shows 42,350 people reported pension contributions exceeding their Annual Allowance through self-assessment in the 2019/20 tax year, compared to just 5,460 in 2015/16.
The total value of pension contributions exceeding the Annual Allowance reported through self-assessment rose from £143 million to £949 million over the same period.
Source: Money Marketing
As you can see from the table above, the total cost of individuals exceeding their Annual Allowance was £253 million in 2019/20. With the Annual Allowance unlikely to rise in line with inflation in the coming years, it’s logical that the number of people affected will also rise.
3 ways your clients could be affected by Annual Allowance issues
The rules governing the Annual Allowance are complex, and it’s easy for clients to be unintentionally caught out. There are three main ways the allowance could affect them.
1. The standard Annual Allowance
In the 2022/23 tax year, clients can pay £40,000 into their pension before they have to pay tax (or 100% of their earnings if lower).
This figure includes both tax relief and any employer contributions, so you can see how easy it might be for a client to pay more than £40,000 into their fund.
Clients with a larger lump sum may be able to use “carry forward”. Here, clients can carry over any unused Annual Allowance from the last three years, meaning they could, in theory, pay up to £160,000 into their pension tax-efficiently in the current tax year.
The calculations and rules can be complex, so seeking advice from a financial planner can add real value here.
2. The Tapered Annual Allowance
If clients have a “threshold income” of more than £200,000 and an “adjusted income” (essentially their threshold income plus pension contributions) of more than £240,000 they may be subject to the Tapered Annual Allowance.
Any client who meets the income requirements above will see their Annual Allowance reduce by £1 for every £2 of “adjusted income” above £240,000.
For example, if a client’s adjusted income was £280,000 their Annual Allowance would be reduced to £20,000.
Note that the taper stops at £312,000, so any client earning more than this will retain an allowance of at least £4,000.
The complex nature of the taper can catch out many clients. You may recall news stories over the last year about highly paid NHS staff refusing overtime because they were facing substantial tax bills because of the taper.
Again, professional advice can be valuable here.
3. The Money Purchase Annual Allowance
If a client has started to flexibly draw an income from their defined contribution (DC) pension, their Annual Allowance is restricted to just £4,000.
Consequently, this Money Purchase Annual Allowance heavily restricts the amount that people still in work – perhaps a part-time or consultancy role – can pay into their pension tax-efficiently.
Pensions Age report that more than 1,000 savers became subject to this reduced allowance every day in 2020.
When clients come to draw their pension income, falling foul of this rule can hamper their desire to build up a larger pension fund.
Looking at alternatives such as taking 25% tax-free cash (which typically does not trigger the Money Purchase Annual Allowance) or supplementing their income from non-pension sources can help them to maximise their tax-efficient savings.
Get in touch
When it comes to managing Annual Allowance issues, it’s easy for clients to be caught out. With more than a quarter of a billion pounds paid in tax charges for Annual Allowance breaches in 2019/20 it’s a problem that can cost a client dearly.
Working with a financial planner can help clients manage Annual Allowance issues, for example by making the most of “carry forward” or carefully structuring their retirement income.
If you have clients who would benefit from advice, or if you’re interested in working more closely with us, please get in touch. Email [email protected] or call us on 0345 505 3500.
A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits.