Higher-earners filing their tax returns before the 31st January will for the first time face the nightmarish rules on pension allowances.
The 2016-17 tax year is the first where the pension annual allowance “taper” has been in place. The rules mean that anyone earning more than £150,000 will see the amount they can save into a pension each year reduced. Approximately 130,000 people earn this much or more.
But because total incomes are difficult to calculate in advance – many higher earners have bonuses, investments and other sources of income in addition to salary – those on lower wages of around £100,000 are also affected.
The changes have created what pensions experts are calling a “nightmare” scenario, and means many ordinary savers must produce two different measures of their income to work out how much they can put into their pension in the tax year.
Contribution limits can vary dramatically – from £40,000 down to £10,000 – so getting it right matters, particularly if you are reaching the end of your career and plan to give your pension savings a last-minute boost.
Part of the problem is that many people will not know how much they will earn until the end of the tax year, making it even more difficult to know how much to contribute without breaching the limits and being subject to a tax charge.
People with a final salary pension will also find that this can affect their allowance.
Working out your annual allowance without a financial or tax adviser is tricky, but not impossible.
Two types of income
Governments have been squeezing the amount you can save into a pension since 2011. For the 2016‑17 tax year you normally receive tax relief on annual contributions of up to £40,000; the value of your fund is also limited to £1m under the lifetime allowance.
As recently as 2010‑11 the limits were £255,000 and £1.8m. But the Treasury has gone a step further and introduced a sliding scale that reduces the annual allowance even further for people on higher incomes.
Jessica List, a technical specialist at Sipp firm Suffolk Life, said this was “one of the most complicated things ever introduced around the annual allowance”.
She added: “It’s also a chicken and egg situation – pension contributions themselves will have an effect on the allowance.”
To work out whether you will be affected you need to calculate a “threshold” and “adjusted” income.
If your threshold income is more than £110,000 and adjusted income is more than £150,000 a year you will be caught and start to see your annual allowance drop from £40,000 to a minimum of £10,000.
Threshold income includes income from all sources, not just your salary. Income produced by investments and buy-to-let properties fall within the scope.
You also have to add any income given up in a salary sacrifice arrangement, used by many employers to lower National Insurance bills, if it was set up after July 8 2015. From this deduct pension contributions you made to personal pensions, such as Sipps, and to workplace pensions. If you have received a lump sum from someone else’s unused pension on their death, this is not included.
If the figure produced is less than £110,000 there is nothing to worry about – your annual allowance will be £40,000. If it is above, however, you need to calculate adjusted income.
The Government estimates that 300,000 people who save into pensions will be in this situation. Adjusted income is calculated in much the same way as threshold income but includes the pension contributions that you and your employer make both from gross pay and via salary sacrifice.
If adjusted income totals more than £150,000 the taper applies and your annual allowance will fall by £1 for every £2 of adjusted income between £150,000 and £210,000. For adjusted incomes of £210,000 or more, the allowance will be £10,000.
However, using what is known as “carry forward”, you will be able to claw back some extra allowance if you have some left over from the previous three tax years. HMRC automatically tops any contributions up by 20pc, but higher and top-rate taxpayers need to claim the extra tax relief through their tax return.
If you have accessed your pension pot using the pension freedom rules introduced in April 2015 your annual allowance is automatically cut to £10,000 and carry forward cannot be used.
However, if you make your withdrawals using a “capped drawdown” plan set up before the freedoms took effect, your limit remains at £40,000.
If you do exceed the limits, HMRC will impose a charge at your marginal rate of income tax.
Your company’s HR department will be able to help you gather some of the information needed – such as the carry forward allowance – although it will not of course have any information on your income from other sources.
Jackie Holmes, a financial adviser at consultancy Willis Towers Watson, warned that “most people are unaware they even have an issue”.
She said people with final salary pensions, which unlike defined contribution pensions will pay guaranteed amounts, face greater challenges still.
“You won’t be able to find out how much has been contributed to your final salary pension until the end of the tax year, when you get your statement,” she said.
You can estimate how much will be added to your pension over a year but, again, this is fairly complicated and can vary between company schemes.
Those who earn bonuses are also likely to run into the problem of not knowing how much they have earned in a year.
Willis Towers Watson provides a free online tool that helps calculate your allowance, but you need to input all your own figures. You can also call a government helpline, the Pensions Advisory Service, on 0300 123 1047.
I’ve contributed as much to my pension as I can. What else can I do?
As the Government continues to restrict tax relief on pensions, more people than ever will find that it is not tax efficient to save any more into their pension, either in a given year or over a lifetime.
However, alternatives are available. The annual Isa allowance increased to £20,000 from April 2017 and there are also more niche tax-efficient schemes such as venture capital trusts and the Enterprise Investment Scheme. The Government gives a 30pc tax break on these investments, which give exposure to fledgling companies.
VCTs are listed on the stock exchange just like conventional investment trusts, although you have to invest when the trust floats to get the 30pc tax break, while investing via the EIS allows direct holdings in small, unlisted firms, so is typically higher risk.
Investors must hold shares in VCTs for five years, and three for the EIS, otherwise the tax credit is reclaimed. Gains on either are tax free and VCTs pay tax-free dividends.
Jason Hollands, of broker Tilney Bestinvest, said: “While clearly attractive to the right investor one mustn’t forget that these are higher-risk investments. The underlying returns don’t have to be stellar to offer a good outcome though.
“If you can get your initial VCT investment out without a loss after five years, turning a net cost of 70p into 100p, that’s equivalent to a 43pc return tax free. But the better VCTs have delivered very good returns on top of the tax reliefs.
“The main challenge however will be availability, as these schemes raise only limited amounts each year – the tight criteria around eligible investments mean there are only a finite number of opportunities.”
However, Nick McBreen, a financial adviser at Worldwide Financial Planning, was more sceptical. “All these assets are part of the mix, but VCTs and the EIS are not for the ordinary person in the street. You have to be really careful to understand the risks and the exit strategy – your money is tied up.
“You should be filling your boots with Isas and making sure you make full use of your capital gains tax allowance first.”
Have you had trouble calculating how much you can save? Get in touch, email [email protected]