Tinkering with the pensions tapering system

The problems caused by the annual pension contribution allowance have been partially addressed, says David Prosser.

Most NHS staff will now escape the trap © Getty

Ministers hope Budget measures announced last week will solve the row over tax on pension contributions that has prompted senior doctors to refuse extra work or even to retire early. But the changes don’t only apply to NHS staff. Anyone previously caught out by complicated rules that reduce pension contribution allowances for high earners could benefit.

The problem centres on the annual allowance: the amount that savers may pay into their private pensions each year. For most people, the cap is £40,000 or your annual earnings if this sum is lower; go over this allowance and you face punitive tax charges. But many high earners only qualify for a reduced annual allowance. Their maximum contribution tapers down according to their income, potentially to as little as £10,000.

Reform or scrap?

Many have called for these complex rules to be scrapped. Instead Chancellor Rishi Sunak substantially increased the income levels that currently bring 250,000 people into the tapering system. This will make a big difference to many of those savers, with the changes costing the Treasury £180m in the 2020-2021 tax year, rising to £670m by 2024-2025.

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To see how you’re affected, first work out your “threshold income”. This is the total of your pre-tax income for the year – including your earnings, your savings and investment income, and any other income you may have. Confusingly, HM Revenue & Customs talks about “net income” in its advice on threshold income. It doesn’t mean income after tax, but the money left after various deductions you are allowed to make. For most people, the only deduction relevant here is your pension contribution.

For any contributions you have made where HMRC has given you tax relief, whether through a workplace scheme or a personal plan, you can include the value of the tax relief in the deduction. The second figure you need to know is your “adjusted income”. This is your threshold income plus any contributions to your pension made by your employer.

So for most people threshold income is total income minus any pension contributions made. Adjusted income is threshold income plus employers’ pension contributions made on their behalf. In the current tax year, anyone with an adjusted income of £150,000 or less doesn’t have to worry about the tapered annual allowance. Anyone above this level is also off the hook if their threshold income is less than £110,000.

However, if you’re above both figures, you get a reduced annual allowance. Your allowance (including your contributions and your employer’s) comes down by £1 for every £2 you’re over the £150,000 income limit. The maximum reduction is £30,000, so if you have income of £210,000 or more, your annual allowance is £10,000.

Same story, new numbers

The Budget keeps this system but changes the figures. From 6 April, the threshold income and adjusted income limits are increasing to £200,000 and £240,000 respectively.

This will take many people out of the tapering system altogether, including most NHS workers. In addition, many of those still caught in the tapering net will be able to make more pension contributions each year without worrying about tax charges.

But it’s not all good news. There will now be a new minimum annual allowance of £4,000. As a result, anyone with an income of more than £300,000 will see their annual allowance drop below the current £10,000 minimum, until they hit the £4,000 minimum at income of £312,000 or more.

Still, most people with a tapered annual allowance will be better off now. They’ll be able to pay more into their pensions, claiming more tax relief as they do so. And even those who do pay tax penalties because they exceed their annual allowance will face lower bills.

David Prosser
Business Columnist

David Prosser is a regular MoneyWeek columnist, writing on small business and entrepreneurship, as well as pensions and other forms of tax-efficient savings and investments. David has been a financial journalist for almost 30 years, specialising initially in personal finance, and then in broader business coverage. He has worked for national newspaper groups including The Financial Times, The Guardian and Observer, Express Newspapers and, most recently, The Independent, where he served for more than three years as business editor.