The Complete Guide To Understanding Pension Allowances
There is a lot to consider when it comes to your retirement. You may be thinking about whether you want to stop work completely or reduce your hours later in life. A pension plan can help you in order to fund the lifestyle and retirement you want. It is important to understand pension allowances as well as how to take your money when you reach retirement age.
This can be a confusing topic which is why we have put together this complete guide to help you understand and begin to put a strategy in place.
What is a Pension Annual Allowance?
A pension annual allowance is a total that you, your employer or any third party can pay in across all your pension plans in a tax year. Any more than this amount that is put in could cause you to receive a tax charge. At the moment, the standard annual allowance is £40,000.
An annual allowance is dependent on two things. First of which is the amount of income that you earn each year. Additionally, whether you take any flexible income from your pension plan will impact this number. However, this does not include any income from an annuity or your tax-free lump sum.
Do Your Earnings Affect Your Annual Allowance?
You can receive tax breaks on your annual contributions worth up to 100% of your annual earnings.
If you have no relevant UK earnings or earn less than £3,600 a year, you can still contribute to a personal pension that uses the relief at source method. This also means you'll qualify to have tax relief added to your contributions up to a certain amount. However, the maximum you can contribute is lowered to £2880 a year.
Moreover, if, for example, you earn £25,000 a year, the most that can be put in is £25,000. This reflects 100% of your annual salary. But your employer can contribute up to the £40,000 allowance.
There are some instances in which you can pay more than £40,000 a year. For example, you can carry forward earlier years’ unused annual allowance.
Unused Allowances from Previous Years
Allowances from the last three tax years that have not been paid in may be carried forward when unused. It could let you pay in more in this tax year, giving you the advantage to make the most of the tax breaks on offer. However, it is important that you recognise that this is still subject to your level of earnings.
Taking Money From Your Pension Plan and the Effect on Annual Allowance
To take more than your tax-free lump sum from your pension plan can lower your annual allowance. This is referred to as the Money Purchase Annual Allowance. The allowance here is £4000 each tax year and cannot be carried forward. This applies if you take your pension pot in lump sums or as a flexible income. However, this won’t be triggered by buying an annuity, getting defined benefit pension payments or cashing in pension plans worth £10,000 or less.
Defined Benefit Schemes
Members of defined benefit schemes, also known as final salary schemes, will not be affected by how much they pay in. Rather, there is a system of rules that decides how much your retirement benefits increase each tax year. This figure can be found in your pension scheme paperwork.
Once you’ve adjusted your contributions and perhaps set aside a little extra you know you won’t be needing - now is the time to ensure you’re aware of where your investments lie. With the possibility of having changed employers quite a few times now, it’s a good idea to get all of the information for different pensions and providers together. This will only make it easier when the time comes to withdraw funds. Check out our resources for more information on transferring pensions.
Annual Allowances for Higher Earners
You are considered a higher earner if you have an “adjusted income” of £240,000. This includes how much your employer pays into your pension plan as well as your salary and any other forms of income you receive each year. As a result, pension, rental income, dividends and interest on savings and sales commission are all a part of this.
Furthermore, if the total is over £240,000, your annual allowance will most likely be reduced by £1 for every £2 over the limit and this will apply until your allowance gets to £4000.
Tapered Annual Allowance
Tapered annual allowance can be difficult to understand in real life. However, below is a simple way to understand how it works. That being said, you should talk to an expert if the tapered annual allowance affects you. By talking to a financial adviser you will be able to get help regarding your choices.
Going Over Your Allowance
But what happens if you go over your allowance? Here are a few examples to help demonstrate what will happen.
Example 1
Let’s say you were to make an overpayment of £10,000 in the 2021/2022 tax year and had an income of £75,000 (higher rate taxpayer). You would need to calculate the tax charge, the overpayment is then added to your income. For this example, your total income would be £85,000.
The overpayment is then liable to tax at 40%. Therefore, this would give you a tax bill of £4000. This is reported via self-assessment.
Example 2
For the sake of a second example, let’s imagine you’ve made an overpayment of £20,000 for the 2021/2022 tax year and your income is £145,000. In order to calculate the tax charge, the overpayment is added to your income, giving you a total income of £165,000.
The additional tax bracket starts at £150,000 so your overpayment would therefore cross two tax bands.
This would mean that £5000 of the overpayment is liable to tax at 40%. The other £15,000 is liable to tax at 45%.
For this example, your overall tax bill would be £8,750 which would be reported through self-assessment.
Lifetime Allowance
This is slightly different in the fact that it presents a limit on how much you can build up in pension benefits over your entire lifetime. As we mentioned above, going over this bracket would see large tax charges.
Currently, the figure for most people stands at £1,073,100 and has been frozen at this level until the 2025/26 tax year.
This allowance applies across each of the pension pots you have open as a cumulative figure. To keep an eye on the value of your funds, checks are usually carried out at a few key points. For example, if you transfer the finances overseas or if you take out a lump sum from a defined contribution scheme.
After the age of 75, you’re usually safe from any more checks but it is still good practice to keep tabs on the value of your pension.
If you think you may exceed the lifetime allowance as the time draws closer - you may want to think about decreasing your contributions or applying for protection that can help you avoid a tax charge.
Get in touch today for expert advice on how to go about this.
Making the Most of Your Annual Allowance and Pension
In order to make the most of your annual allowance and pension you should make sure you benefit from tax breaks while you can. Government tax breaks for your pension contributions at higher income tax rates may not always be available so make the most of these while it is still possible.
When paying into your pension plan, it’s essential to remember that your pension is invested and can go up as well as down and that you can get back less than what was paid originally.
Secondly, make sure you use up any allowances from previous tax years. You can find out how much-unused allowance you have by asking your pension provider.
If you do have any unused allowance, you may be able to carry it forward to the next year. Alternatively, you or your employer could pay more into your pension plan this year.
Lastly, if you have an ISA or any other form of savings, you could consider putting these in your pension plan and benefiting from the tax break. You should think about doing this while you are still at work. If you have no earnings, you can only pay £3600 each year. Before choosing where to save, you should think about what is right for you. If you need your savings before the age of 55, keeping them in an ISA may be a more preferable solution.
Summary
The topic of pension allowances can often cause a lot of confusion. As it stands currently, the standard annual allowance is £40,000. This refers to the total that you, your employer or any third party pays across all your pension plans in a tax year.
Furthermore, tax breaks are received on any payments within a pension plan but annual allowance will limit how much can be done. This will include any basic rate tax relief boost put into your pension plan. For those, with no income coming in, the limit is considerably less at £3,600 a year.
In order to make the most of your annual allowance and pension make sure you benefit from tax breaks while you still can. Additionally, make sure you use up any allowance from previous years. Lastly, if you have an ISA or any other form of savings, you can consider putting these in your pension plans to further benefit from tax breaks.
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