Pension Pitfalls Part 2 – High Earners
This post is the second in our ‘pension pitfalls’ mini-series, which is intended to highlight some of those areas which we feel can catch individuals out when it comes to their pension planning, or could mean that the tax advantages of the pension aren’t being fully utilised.
Personal pension contributions are eligible for tax relief at an individual’s highest marginal income tax rate. There are two types of way in which these contributions can be made, either using the ‘net pay’ method or the ‘relief at source’ method.
When contributions are made via ‘net pay’, income tax relief is automatically given at your highest marginal rate. Where contributions are made via ‘relief at source’, the only tax relief immediately given is basic rate (20%) – this uplifts the net contribution to a gross contribution. If eligible for 40% or 45% tax relief, this would need to be reclaimed as part of the individual’s tax return.
We find many individuals are not aware of the practicalities of pension tax relief, and have been high earners for a number of years without maximising the tax relief available to them. It is possible to backdate any claims to cover relief which should have been claimed in the last 4 tax years.
The tapered annual allowance was introduced on 6th April 2016. This impacts the amount that high earners can contribute to their pensions by tapering the allowance down from £40,000 to £10,000 for individuals with ‘adjusted income’ in excess of £150,000 (by £1 for every £2 of income) – this meant that if someone earnt £210,000 or more, contributions to their pension which were eligible for tax relief were capped at £10,000.
In April 2020, changes were made to this tapering which brought the lower limit to just £4,000. At the same time, the ‘adjusted income’ limit was increased to £240,00 and therefore the £4,000 limit would apply for those with earnings in excess of £312,000.
We find many individuals were aware of the initial tapering and reduced their pension contributions to the £10,000 limit but have overlooked the further reduction. Any contributions in excess of the allowance will be subject to an annual allowance tax charge, which is at an individual’s marginal rate of income tax – for those impacted by the tapered allowance this will be 45%.
Whilst the amount that can be contributed to pension in a tax year (and is eligible for tax relief) is limited, it is possible to use ‘carry forward’ to sweep up missed contributions from the previous three tax years. Before using any carry forward allowance, the full contribution allowance for the current tax year must be fully utilised.
Once the current tax year’s allowance has been utilised, the order in which any available allowance is used starts at the furthest tax year back. This is shown in the table below.
As the carry forward rules are based on a rolling 4-year period, moving into a new tax year means the loss of the oldest allowance – once we enter 2022/23, there will no longer be the ability to use unused scope from 2018/19.
Given the preferential tax treatment of pensions, this is often valuable scope and it’s important to be on top of your available allowances and when these need to be used by.
Auto enrolment was introduced in 2012, and since this date there has been a requirement for employers to provide pension funding for ‘eligible employees’. If an individual doesn’t want to receive pension contributions then they would need to ‘opt-out’.
Most workplace pension contributions are expressed as a % of salary, and for high earners, these contributions can be sizeable. For an individual who earns £300,000, an 8% pension contribution (4% employee, 4% employer) would equate to a contribution of £24,000 and would be in excess of the available Annual Allowance (covered in point 2 above). Any contributions in excess of the Annual Allowance will be taxed at your marginal income tax rate.
We also find this to be a common scenario for those who change their employment status – for example, moving from being a Partner to more of a consultancy role where they are classed as an employee. This employee position will come within auto-enrolment, and it’s important to be mindful of this and the contribution limits. We also tend to see these individuals have built up large pension pots throughout their working career, and whilst not covered in detail here the ‘Lifetime Allowance’ would also be a consideration.
Some employers may offer an alternative remuneration structure if pension contributions are not feasible, and it’s important to ensure all options are thoroughly explored.
As well as offering tax-relief at an individual’s highest marginal rate, personal pension contributions can be used as a strategic tool to minimise tax liabilities and even reinstate tax allowances which may have been lost during the year. The calculation for any personal pension contributions made will work by extending an individual’s basic rate tax band by the gross contribution amount, which in turn then provides higher/additional rate tax relief by reducing the amount of income that is subject to that tax level.
The strategic example of this we see most often is related to the Personal Allowance (the 0% income tax band) which is lost at a rate of £1 for every £2 of earning above £100,000 – therefore an individual who earns in excess of £125,140 would lose the full amount. Making a personal pension contribution which then brought the ‘adjusted net income’ (income, less personal pension contributions) down either below £100,000 or between the tapered amounts would provide tax relief at an effective rate of 60%.
Other ways in which pension contributions can be used are to reduce the impact of the tapered annual allowance or to reduce the impact of the high-income child benefit tax charge.
This is a technical area of strategic planning, and whilst we would always advocate taking advice in relation to this, it’s important to be aware of the broad ideas and tax levels involved.
The information featured in this article is for your general information and use only and is not intended to address your particular requirements. Whilst knowledge is power, the best way to naturally avoid any of these pitfalls is to take financial advice along the way from a pension specialist. Five Wealth Ltd offer independent financial advice to a wide variety of clients, at various stages throughout their investment and retirement planning journey. If you feel that our expertise would be beneficial to you, please get in touch.
The information contained within the article is based upon our understanding of HMRC legislation and practice. Thresholds, percentage rates and tax legislation may change in subsequent Finance Acts and their value depends on the individual circumstances of the investor.
A pension is a long-term investment not normally accessible until 55 (57 from April 2028). Your capital is at risk. The value of your investment (and any income from them) can go down as well as up and you may not get back the full amount you invested.
Workplace pensions are regulated by The Pensions Regulator.
Please keep an eye on our blog posts/linked in to see parts 1 and 3 of this ‘pension pitfall mini-series’, specifically focusing on considerations for pre-retirement and those approaching retirement.