What a caper over a taper!

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(This article was last updated on 24 May 2016).

In its Summer Budget Statement of 8 July 2015, the government announced that changes to the annual allowance rules for pensions would be introduced from 6 April 2016 in the form of a tapered annual allowance that will reduce the annual allowance available to high earners. 

Why the taper?

The government confirmed that the reasons for introducing a tapered annual allowance are to:

  • pay for reforms to inheritance tax rules that were announced in the Summer Budget of 2015, and
  • control the amount that giving tax relief on pensions costs the government. In the short term, the government wants to make sure that support to pension savers is affordable and targeted where it is needed most. 

There will be a reduced annual allowance from 6 April 2016 for those with an ‘adjusted income’ of over £150,000. The reduction will work through the operation of a £1 reduction in the annual allowance for every £2 of adjusted income above £150,000. So, those with an adjusted income of £210,000 or more in a tax year will have a £10,000 annual allowance for that tax year.

However, if an individual’s ‘threshold income’ is no more than £110,000 they will not normally be subject to the tapered annual allowance.

Before we go onto look at how the taper will work, it’s worth covering what adjusted income and threshold income are. 

Broadly, it includes all taxable earnings and all pension contributions less certain reliefs. To expand on this, the government have confirmed that the definition of adjusted income will be:

Step 1: Calculate total income for a tax year that will be subject to income tax. For example, this includes employed and self-employed earnings, pension income, interest on savings, dividend income and rental income.

Step 2: Add in the amount of any excess tax relief claimed on personal contributions to an occupational pension scheme (this is tax relief claimed on employee contributions paid direct to an occupational pension scheme rather than through pay) and the amount of any tax relief given on a personal pension contribution following a claim made by an individual (this is tax relief on gross contributions paid to a retirement annuity contract).

Step 3: Add in the amount of any employee pension contributions deducted from pay under the ‘net pay’ method used for occupational pension schemes. Employee contributions to an occupational pension scheme are deducted gross from gross pay (ie, before income tax is calculated).

Step 4: Add in any relief claimed by non-domiciled individuals for personal contributions made to an overseas pension scheme.

Step 5: Add the value of any employer contributions paid in a tax year. This includes any employer contributions being paid to any type of pension arrangement. For a defined benefit scheme, this is the amount of accrual for the tax year less any employee 'net pay' contributions. This also includes any employer contributions as a result of salary sacrifice arrangement.

Step 6: Deduct the amount of certain lump sum death benefits paid to an individual in a tax year. These are any lump sum death benefits that are subject to tax based on the recipient's marginal rate.

Looking solely at pension contributions, this means that for calculating adjusted income you would:

  1. Calculate total earnings subject to income tax (note - this should be gross earnings less any employee contributions to an occupational pension scheme that are deducted from pay).
  2. Add in any employee contributions to an occupational pension scheme that are deducted from pay (yes - you are adding back in the same amount you have just deducted in the bullet point above!).
  3. Add in any employer pension contributions to an occupational pension scheme or to a personal pension.

In simple terms, it’s a person’s income but without adding back in any employer pension contributions. Here’s how threshold income is calculated:

Step 1: Calculate total income for a tax year that will be subject to income tax. For example, this includes employed and self-employed earnings, pension income, interest on savings, dividend income and rental income.

Step 2: Deduct the amount of certain lump sum death benefits paid to an individual in a tax year. These are any lump sum death benefits that are subject to tax based on the recipient's marginal rate.

Step 3: Deduct the gross amount of any contribution paid using the relief at source method. This is the gross amount of any personal contributions paid to a personal pension. Personal contributions to a personal pension are paid net of basic rate tax relief from a person's net income (ie, after income tax has been deducted).

Step 4: Add the amount of any employment income given up for pension provision as a result of a salary sacrifice or flexible remuneration agreement made on or after 9 July 2015. This step is included to prevent anyone from using salary sacrifice to manipulate their income so that the tapered annual allowance rules won't apply.

Looking solely at pension contributions, this means that for calculating threshold income you would:

  1. Calculate total earnings subject to income tax (note - this should be gross earnings less any employee contributions to an occupational pension scheme that are deducted from pay).
  2. Deduct any gross personal contributions paid to a personal pension.
  3. Ignore any employer pension contributions to an occupational pension scheme or to a personal pension.

Here’s some examples showing how the reduction in annual allowance will work once adjusted income has been calculated:

Adjusted income Reduction in annual allowance Annual allowance
£140,000 £0 £40,000
£150,000 £0 £40,000
£160,000 £5,000 £35,000 (tapered)
£170,000 £10,000 £30,000 (tapered)
£180,000 £15,000 £25,000 (tapered)
£190,000 £20,000 £20,000 (tapered)
£200,000 £25,000 £15,000 (tapered)
£210,000 £30,000 £10,000 (tapered)
£220,000 £30,000 £10,000 (tapered)

In practice, most people's salaries will not be round £000's. If the amount of the reduction in the annual allowance is not a multiple of £1, then the tapered annual allowance is reduced to the nearest multiple of £1. For example, if someone's salary is £187,595, then the reduction in the annual allowance would be £18,797.50. The tapered annual allowance would then be £21,202.50 but this would be rounded down to £21,202.

So, for the 2016/17 tax year, it should be a case of working out what an individual’s threshold income is. If income is at or below the threshold limit of £110,000 then the tapering rules will not apply. If income is above the threshold limit then the scope for making pension savings should be fairly clear.

For example, if an employee’s threshold income is £140,000 then a £10,000 employer pension contribution would result in adjusted income of £150,000 and there would no annual allowance charge. A £40,000 employer pension contribution would result in adjusted income of £180,000 so the tapered annual allowance would be £25,000 meaning £15,000 of the pension contribution may be subject to an annual allowance charge, unless there is any unused carry forward allowance from previous tax years.

It will be possible to use carry forward where the tapered annual allowance applies in a tax year. So, any unused annual allowance from the three tax years prior to the tax year in question can still be carried forward as normal.

Where the annual allowance has been reduced in a carry forward year as a result of the taper provisions, then the carry forward available will be based on the tapered annual allowance amount. For example, if 2016/17 is a carry forward year and £7,000 of contributions were made when a £10,000 tapered annual allowance applied, then there will be £3,000 of unused annual allowance to carry forward. 

The mandatory scheme pays conditions have not changed following the introduction of the tapered annual allowance.

Scheme pays is a process that allows an individual to pay an annual allowance charge from the funds held in their pension arrangement. This means the scheme pays the annual allowance charge direct to HMRC on the individual's behalf, and the tax charge is taken out of their pension fund. 

Mandatory scheme pays should only be available based on the full annual allowance amount of £40,000. So, if someone has made contributions to a registered pension scheme of more than £40,000 and their annual allowance tax charge is more than £2,000 then they could ask to use scheme pays on a mandatory basis and the scheme would need to agree to do this.

Where the mandatory conditions are not met, a scheme pays request could still be made on a voluntary basis although the scheme is not obliged to accept this. 

Where someone is subject to the MPAA provisions because they have ‘flexibly accessed’ pension benefits since 6 April 2015, and they are also subject to the taper provisions, the taper is applied to their alternative annual allowance amount. The alternative annual allowance amount is the standard annual allowance less the £10,000 MPAA.

This means that where someone is subject to the maximum taper provisions, their alternative annual allowance for defined benefit pension savings will be nil. They would, however, still have a £10,000 MPAA limit and would still be able to use carry forward for any unused defined benefit pension savings from the previous three years. 

One knock-on effect of the tapered annual allowance rules is that the government is aligning every pension input period to run in line with tax years. This effectively begins from 6 April 2016 with transitional rules applying for the 2015/16 tax year. This affects everyone making pension savings and you can find out more about this in our article here.

Summary

The tapered annual allowance brings another layer of complexity onto the annual allowance rules as, from 6 April 2016, there will be rules for the normal annual allowance, the money purchase annual allowance, the tapered annual allowance and carry forward. In practice, advisers, accountants and HR payroll teams will be getting called on to help provide and produce information to work out whether the tapering rules apply or not.

It’s worth remembering that people should still claim higher and additional rate tax relief on any pension contributions they pay that are within their relevant UK earnings. If the tapered annual allowance amount is exceeded, then any annual allowance tax charge that subsequently arises will effectively claw back some of that tax relief. It’s also worth remembering that any annual allowance charge arising is always payable by the individual, even if the excess savings have arisen through the payment of employer contributions.

It’s been well reported that the tapering rules will cause difficulties for some people – such as the self-employed, employees with fluctuating earnings, those who receive large bonuses or those with defined benefit savings. It will be interesting to see what effect the rules will have in practice and whether they will affect benefit packages or salary levels for some people, the general level of pension savings being made before and after the tapering rules are introduced, the timing of bonus payments, the amount of tax relief given by HMRC or the amount of tax that is paid to them for annual allowance charges.  

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