The allowance remains one of the trickier areas of pensions legislation
We are now entering the busiest time in our calendar – the mad last two months before the end of the tax year. One of the tasks for advisers working with their higher earners is to establish what their tapered annual allowance will be for the 2018/19 tax year, and what this means for any pension contributions they have paid or want to pay this tax year.
The tapered annual allowance has been with us for nearly three years, and it remains one of the trickier areas of pensions legislation. It is a circuitous process. The higher earner may not know what the full value of their income is until the very end of the tax year (for example, some businesses pay their bonuses at the end of March).
But the amount of their taxable income will drive how much they can contribute to their pension in the tax year without triggering an annual allowance charge. With this in mind, many may be left in the position of accidentally exceeding their tapered annual allowance or possibly being too cautious and not contributing as much as they could.
There is no doubt that the tapered annual allowance has had an effect. HM Revenue & Customs statistics published last September showed around 16,500 reported in their self-assessment exceeding their annual allowance, compared with only 5,400 the previous year.
Although HMRC does not report tapered annual allowance breaches separately it is probably a good guess some of this increase in numbers is down to the new allowance.
Of course, if people do exceed their tapered annual allowance then they can carry forward any unused annual allowance from the previous three tax years to mop up any excess. But after two years of having to cope with tapered annual allowance, it is probably true to say if they had unused allowance, many may have now exhausted it.
And remember that this tax year – 2018/19 – is the last opportunity that someone who has continually been a high earner has to be able to make the most of any of their unused £40,000 annual allowance from 2015/16 (as from 2016/17 their annual allowance would have been tapered). To do this, the high earner would need to have had a pension account in 2015/16, even if they were not contributing.
It is worth examining the exact calculation for tapered annual allowance. It applies to anyone who has an adjusted income of over £150,000 and a threshold income of over £110,000. Both values are calculated with reference to the “net income”. This is a rather confusing piece of terminology as it does not refer to net income as most people probably know it. Instead, it is the amount subject to income tax less certain tax reliefs – in other words “gross income”.
The Income Tax Act 2007 sets out the detail. Taxable income includes earned salary, self-employed profits, some state benefits, most pensions, most rental income, employment benefits, income from a trust and investment income. This can be reduced by some tax reliefs.
For the self-employed, most important is the ability to deduct trading losses from general income (subject to certain limits). They can also deduct certain loan interest payments, for example a loan taken out by somebody to fund their capital contributions when they become an equity partner in a professional practice.
Everyone can reduce their net income by making a charity donation, but only if the donation is in the form of shares, securities or real property. So although a cash donation would not affect the net income calculation, an in-specie charitable donation of shares would.
Pension salary sacrifice does reduce taxable income but, of course, the value of the employer contributions for salary sacrifice arrangements entered into after 9 July 2015 is then added back in when calculating the value of adjusted income.
Therefore, entering into a pension salary sacrifice arrangement now does not avoid tapering.
However, salary sacrifice arrangements for employer-provided pension advice, childcare vouchers, directly employer-provided childcare that started before October 2018 and the Cycle to Work scheme could all help to reduce the net income.
Tapered annual allowance remains a headache for many higher earners paying into pensions.
However, despite the reports of it impacting on higher-paid public sector workers – for example the likes of doctors and headteachers – there is no sign that it will be removed any time soon.
Instead, advisers and their clients need to understand its nuances and learn to manage it.
Rachel Vahey is product technical manager at Nucleus