Saving into a pension is one of the most tax-efficient ways to prepare for your retirement. Not only do pensions enable you to grow your retirement savings largely free of tax, but they also provide tax relief on the contributions you make. In this article, George Square Financial Management explains how to make the most of your pension allowances.
To make the most of your pension allowances, you need to understand what allowances and thresholds might apply to you and how to maximise them. The various pension allowances available can limit the amount of money you can contribute to a pension in a year, as well as the total amount of money you can build up in your pension accounts while still enjoying the full tax benefits.
Aside from the State Pension and overseas pensions, all your pensions count towards the lifetime allowance. This includes workplace pensions. The standard lifetime allowance has stood at £1,073,100 since 6 April 2020 and increases with inflation each year. You do not need to pay a tax charge until you take your pension savings over and above your lifetime allowance (or reach age 75, if earlier). The charge is only on the excess money saved in your pension that is above your lifetime allowance limit.
Non-taxpayer or earning less than £3,600
If you have no earnings or earn less than £3,600 a year, you can still pay into a pension scheme and qualify to receive tax relief added to your contributions up to a certain amount. The maximum you can contribute is £2,880 a year.
Tax relief is added to your contributions. For instance, if you pay £2,880, a total of £3,600 a year will be paid into your pension scheme. This is even if you earn less than this or have no income at all. This applies if you pay into a personal or stakeholder pension yourself (as opposed to through an employer’s scheme) and with some workplace pension schemes – but not all. The way some workplace pension schemes give tax relief means that people earning less than the personal allowance (£12,500 in the 2020/21 tax year) won’t receive tax relief.
Money purchase annual allowance
The Money Purchase Annual Allowance (MPAA) rules were introduced as an anti-avoidance measure to help prevent widespread abuse of the pension freedoms, which commenced from 6 April 2015. It’s intended to discourage individuals from diverting their salary into their pension with tax relief and then immediately withdrawing 25% tax-free.
The MPAA applies only to money purchase contributions and has remained at £4,000 since 6 April 2017. If you have taken flexible benefits that include income, such as an ‘Uncrystallised Funds Pension Lump Sum (UFPLS)’ or flexi access drawdown with income – and you want to continue making contributions to a defined contribution pension scheme – you will have a reduced annual allowance of £4,000 towards your defined contribution benefits.
The pension annual allowance is the maximum amount of money you can contribute towards a defined contribution pension scheme in a single tax year and receive tax relief on. All contributions made to your pension, as well as any tax relief received, count towards your annual allowance.
The standard pension annual allowance is currently £40,000, or 100% of your income if you earn less than £40,000. However, a lower annual allowance may apply if you are a high earner or have already started accessing your pension. High earners may potentially be subject to the Tapered Annual Allowance. Those who have already started accessing their pension potentially face the Money Purchase Annual Allowance (MPAA).
Carry forward is a way of increasing your pension annual allowance in the current tax year. It is used when your total pension contributions for a tax year exceed your annual allowance limit.
You can carry forward unused allowances from the three previous tax years to make contributions this year. This may enable you to absorb or reduce any pension annual allowance excess paid in the current tax year. This in turn would reduce any potential annual allowance charge amount. The 2020/21 tax year allows use of unused allowances from 2017/18, 2018/19 and 2019/20.
Tapered annual allowance
The tapered annual allowance calculations does not affect anyone whose income is below £200,000. The taper starts in this tax year at £240,000 and extends to a minimum of £4,000 annual allowance. This reduces the level of pension funding high earners and their employers can make into pension schemes.
If high earners exceed the threshold and adjusted income amounts, their annual allowance may be reduced by £1 for every £2 of adjusted income over this level until the minimum annual allowance level of £4,000 is reached. The maximum tapered annual allowance reduction is £36,000.
Pension contributions tax relief
Working or not, everyone is entitled to receive basic-rate tax relief at 20% from the government when making contributions to their pension.
Depending on the type of pension, tax relief can either be a reimbursement of the tax already paid on a pension contribution or it can be the ability to put away for your pension straight out of your wage, before paying any tax.
Basic-rate taxpayers, and those who don’t pay tax, will earn 20% tax relief. Higher-rate tax payers earn 40%. For additional-rate income taxpayers, who earn over £150,000 a year, tax relief is 45%. There are other rules that apply for additional-rate payers depending on specific circumstances.
Pension allowances: are you getting close to your annual pension limits?
It’s a good idea to keep track of your pension contributions; this is so that you know if you’re getting close to your annual pension limits. Whatever challenges and opportunities retirement presents, it is important to make the most of your pension allowances.
We understand that pensions can be confusing. Our experienced financial advisers can help you ensure that you are making the most of the tax allowances available to you.
Call us for a free consultation on 0115 947 5545, or send an enquiry here.
Read more about our tax planning services here.