In this month’s article in his ‘Keep It Simple’ series, Neil Da Costa tackles a topic that examiners always say students struggle with – pensions.
HMRC gives individuals tax relief to encourage them to make pension contributions.
Occupational and personal pensions
Occupational pensions are set up by the employer for the benefit of their employees. Employee contributions are made gross and are deducted on the employee payslip. The benefit for the employee is the costs of setting up the pension are borne by the employer. In addition, employer pension scheme contributions are a tax-free benefit.
Contributions to a personal pension scheme are paid net of basic rate income tax (20%). Tax relief at the higher and additional rate is given by extending the basic rate and higher rate bands by the gross pension contributions.
Simple example: Mabel
Mabel is a higher rate taxpayer who earns £40,000 a year.
She contributes £4,000 into an occupational pension and another £4,000 into a personal pension she had set up previously.
Explain the tax implications for Mabel.
Solution to Mabel
The occupational pension contributions of £4,000 are made gross and will be deducted from Mabel’s gross salary of £40,000. As a result, she will only pay income tax on £36,000 salary.
The £4,000 personal pension contributions are not deducted from Mabel’s income. Instead, the gross amount £4,000 x 100/80 = £5,000 is added to both Mabel’s basic rate band and higher rate band. As a result, an extra £5,000 of her income will be taxed at 20% instead of 40%.
Maximum pension contributions
The maximum pension contributions an individual can make each year is computed based on the higher of £3,600 and 100% of net relevant earnings (employment income, self-employed profits, and furnished holiday lettings).
This is restricted to an Annual Allowance of £40,000. The annual allowance applies to total pension inputs (both employee and employer contributions).
Simple example: Charles
Charles has a self-employed profits of £35,000 and rental profits of £15,000.
Compute his maximum pension contributions and explain the implications if his actual gross pension contributions were £45,000.
Assume he is a higher rate taxpayer.
Solution to Charles
The maximum pension contributions Charles can make is the higher of £3,600 and 100% of his net relevant earnings. We must ignore the rental profits as these are not earnings.
As a result, the maximum pension contributions permitted are £35,000 which is within the £40,000 annual allowance.
Charles has actually made pension contributions of £45,000 which results in a pension tax charge based on the excess pension contributions of £10,000.
Assuming Charles is a higher rate taxpayer, the pension tax charge will be £10,000 x 40% = £4,000 which will be added to his tax liability.
Unused Annual Allowance (AA)
After utilising the current tax year AA of £40,000, it is possible to use up any unused AA of the three previous tax years on a FIFO basis.
An individual must be a member of a pension scheme in order to have an unused AA.
Simple example: Oliver
Oliver has earnings of £60,000 each year but has been contributing just £10,000 into his pension in the past. What is the maximum pension contributions Oliver can make in the current tax year without incurring a pension tax charge?
Solution to Oliver
The annual allowance for the current tax year is £40,000.
In addition, Oliver is allowed to use up his unused relief of £30,000 per year for the three previous tax years on a FIFO basis. This will allow him to make additional pension contributions of £90,000.
The total pension contributions permitted for Oliver will therefore be £40,000 + £90,000 = £130,000.
Oliver will be entitled to claim an income tax refund for the 3 previous tax years.
Tapered Annual Allowance
The annual allowance of £40,000 is reduced if threshold income is more than £200,000 and adjusted income exceeds £240,000.
Threshold income is net income less gross personal pension contributions.
Adjusted income is net income plus employee occupational contributions and any employer contributions.
The formula for reducing the AA is 50% (Adjusted Income – £240,000).
The annual allowance cannot be reduced to less than £4,000.
Simple example: Cara
Cara has a salary of £230,300 and receives bank interest of £9,000.
She makes gross personal pension contributions of £20,000 and her employer also contributes £24,000 into her pension scheme.
What is Cara’s annual allowance for the current tax year?
Solution to Cara
Step 1: Threshold Income
Net income is employment income added to the bank interest (£230,300 + £9,000) = £239,300.
We then deduct Cara’s personal pension contributions £239,300 – £20,000 = £219,300. This figure is more than £200,000 so we now check the adjusted income.
Step 2: Adjusted Income
Adjusted income is net income £239,300 plus employer pension contributions.
£239,300 + £24,000 = £263,300. This figure is more than £240,000 so tapering will apply.
Step 3: Taper AA
£40,000 – 50% (263,300 – £240,000) = £28,350.
This means that Cara’s AA for the current tax year is tapered down to £28,250.
You have now understood pensions and can easily earn marks on this popular exam topic.
• Neil Da Costa is a Senior Tax Lecturer with Kaplan in London.
He is the author of Advanced Tax Condensed and Tax Condensed, which summarise the entire syllabus using accelerated learning memory joggers