17/01/20The tapered annual allowance: What you need to know

Managing pension contributions and tax liability can be tricky. If you are affected by the tapered annual allowance, it can be even more challenging. The Secretary of State for Health and Social care has announced there will be a review into the impact of the tapered annual allowance and its impact on NHS staff, but it is not just NHS staff that should ensure they understand how it works.

What is the tapered annual allowance?

When you are saving into a pension there are two allowances you need to keep in mind: the annual allowance and the lifetime allowance. These two allowances limit how much you can save tax-efficiently in pensions. As the name suggests, the annual allowance dictates how much you (and others on your behalf, such as your employer) can contribute to pension plans in a tax year without you suffering an income tax charge. For Defined Benefit schemes, such as the NHS scheme, the annual allowance relates to the increase in promised benefits over each tax year rather than the contributions made.

The lifetime allowance refers to the total amount accrued in your pension plans over your working life.

If either allowance is exceeded, some of the personal tax relief obtained may be clawed back at a later date, depending on the source of contributions or funding. It could affect your retirement plans if this hadn’t been expected.

For the 2019/20 tax year, the annual allowance is a maximum of £40,000 (except if there is unused annual allowance in the previous 3 tax years, it can be possible to use this to increase the current year’s annual allowance). However, it is not as simple as having an allowance that applies to every worker. In some cases, your allowance may be significantly lower. One of the reasons for this is the tapered annual allowance.

If your threshold income is over £110,000 and your adjusted income is over £150,000, you will be affected by the tapered annual allowance.

First, what are the definitions of threshold and adjusted income?

  • Threshold income is your annual income before tax as for adjusted income below, excluding pension contributions and ignoring any employer contributions
  • Adjusted income broadly covers all income that you are taxed on, this may include dividends, savings interest and rental income before tax, but including the value of your own and any employer pension contributions

Next, how much is your annual allowance reduced by? If your threshold income is over £110,000 and your adjusted income is over £150,000, then for every £2 your income exceeds £150,000, your annual allowance will reduce by £1. The maximum reduction is £30,000. This means some workers (those with adjusted income of £210,000 or more) can be left with an annual allowance of just £10,000.

If total contributions from all sources exceed your annual allowance and you will pay income tax on the excess. This could mean an unexpected tax bill if you are not aware of your pension position. It is worth noting that unused annual allowance from the previous three tax years can be carried forward if eligible.

NHS: Bringing the tapered annual allowance to the forefront

The tapered annual allowance has been featuring in the news due to the issues it is causing in the NHS. High earners within the NHS have found they can face an unexpected tax bill if they work overtime or receive a pay increase. This has led to some senior members of staff turning down additional work over fear they will need to pay out more. The annual allowance position is more complex to understand with defined benefit pensions where it is the annual increase in pension benefits that is tested, rather than the contributions made by employer and employee.

As a result, Matt Hancock, Secretary of State for Health and Social Care, has stated there will be an ‘urgent review’ into the tapered annual allowance for pension relief. Solutions put forward so far include allowing NHS staff to flexibly change their accrual rate and adjust it where necessary to reflect earnings.

Whilst the review is good news for NHS staff, there have not been any suggestions that it could be extended to other industries. However, some are calling for the tapered annual allowance to be scrapped altogether.

Steve Webb, Director of Policy at Royal London, said: “The tapering of the annual allowance has caused major problems in the NHS. All year we have been hearing of doctors who are restricting their hours to avoid the risk of large lump sum tax bills.

“The tapered annual allowance is complex and makes it very hard for taxpayers to know where they stand. The solution is to abolish the taper outright, even if this means a lower across-the-board annual allowance for all.”

Managing your annual allowance

If you are affected by the tapered annual allowance, it is important you manage your pension contributions (easier to do with money purchase/defined contribution pensions than with defined benefit pensions). This can help make the most of your savings and reduce your tax liability.  There are several key things to do if you are worried about the annual allowance.

  1. Understand your annual allowance: The first step is to make sure you understand exactly what your annual allowance is. This can be difficult if you are affected by the tapered annual allowance, but it means you can seek to control your pension contributions/funding, so you do not face an unexpected bill and so that you can maximise your tax-efficient retirement savings.
  2. Make use of carry forward: If you have recently been affected by the tapered annual allowance, it may be possible to use carry forward to help you save more tax efficiently. If you do not use unused allowances from previous tax years, they will disappear after three years. In order to use carry forward you must have been a member of a pension plan in those earlier years.
  3. Manage contributions: Actively keeping an eye on your pension contributions is important if you may exceed your annual allowance. You can adjust or even pause your contributions to ensure you do not pay avoidable tax. The position is more complex if you are a member of a defined benefit pension scheme (final salary/career average).
  4. Work with a financial planner: A financial planner can help you make the most out of your savings. If you would like to maximise pension savings whilst mitigating avoidable tax on contributions, please get in touch. We will work with you to create a bespoke financial plan that considers your personal circumstances, including the tapered annual allowance where necessary.

Please note: 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. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation which are subject to change in the future.

The Financial Conduct Authority does not regulate tax advice.

This article is for general information only and is not intended to be individual advice.