Understanding your pension allowances

One of the best things about a pension is the tax relief you get on any contributions you or your employer make, but there are limits to the taxman’s generosity.

When you or your employer pay into a pension, you’ll get tax relief at the basic tax rate of 20%. So, for every £80 that goes into your pension, the taxman will boost this to £100. If you’re a higher or additional rate taxpayer, you can claim back an extra 20% or 25% in tax relief on top of the 20% basic rate relief through your tax return.

The amount you can save into a pension and earn tax relief on is capped each year, known as your Annual Allowance. There’s also a Lifetime Allowance, which is the total amount you can save into your pension without being hit by a tax charge. Here, we explain how both these allowances work so that you don’t fall foul of the rules.

How much is the Annual Allowance?

If you pay into a defined contribution pension, sometimes known as a money purchase pension, you can pay in up to 100% of your earnings into your pension each tax year, up to a maximum Annual Allowance of £40,000. If you have a defined benefit or final salary pension, the Annual Allowance relates to the total amount of benefits you can build up in your scheme each year for tax relief purposes.

You can also ‘carry forward’ any unused Annual Allowance from the last three years as long as you were enrolled in a pension scheme during that time. This can be helpful if you have a big lump sum that you want to invest one year.

If you’re a particularly high earner, you may also get a lower Annual Allowanc.. For every £2 of income you receive above £150,000, you’ll lose £1 of your annual allowance down to a minimum of £10,000 for those earning over £210,000.

What happens if I go over the Annual Allowance?

If you pay more than the Annual Allowance into your pension, you’ll have to pay what’s known as an Annual Allowance charge. HMRC has a useful Annual Allowance calculator to help you work out whether you have to pay tax on your pension savings.

The Annual Allowance charge isn’t a set rate – the amount you’ll pay will depend on which income tax bracket you’d fall into if your excess pension savings are added to any other taxable income you get. That means the charge could be 20%, 40% or 45% of any pension savings you made above the Annual Allowance, depending on your circumstances.

If you think you may have paid in more than your Annual Allowance, it’s always worth checking your contributions over the last 3 years to see if you may have some unused Annual Allowance from prior years that you could carry forward before having to pay additional tax.

Does my Annual Allowance stay the same once I’ve started taking money from my pension?

No, once you’ve started taking money out of your defined contribution pension, your Annual Allowance falls from £40,000 to £4,000 and becomes known as the Money Purchase Annual Allowance (MPAA). However if you take a 25% tax-free lump sum out of your pension but not any income, you can still hang onto your full Annual Allowance.

How does the Lifetime Allowance work?

The Lifetime Allowance is the maximum you can save in your pensions without having to pay any extra tax charges when you take money out of them. It doesn’t include any income coming from the State Pension.

In the current 2019/20 tax year, the Lifetime Allowance is £1.055m, but this is expected to rise to £1.075m in the 2020/21 tax year which starts on April 6, 2020. As it stands, the Lifetime Allowance is expected to increase inline with CPI every April, although this is something that future Governments may review in time so be sure to check.

What happens if my pension savings are more than the Lifetime Allowance?

If the value of your pensions is higher than the Lifetime Allowance, you’ll have to pay a tax charge on anything above it, and you should get a statement from your pension provider which will show how much tax you owe.

The amount you’ll be charged depends on how you’ve chosen to take money out of your retirement savings.

Any amount over your Lifetime Allowance taken as a lump sum, for example, will be taxed at a rate of 55%, whereas if you make cash withdrawals or receive the money as pension payments, you’ll be taxed an additional 25% on top of any regular tax payable on your pension income.

So, if you pay tax at the higher rate and expected to get £10,000 a year in income from your pension, the Lifetime Allowance charge would reduce this to £7,500 a year. After income tax at a rate of 40%, you’d be left with an income of £4,500.

How is this tax charge paid?

If you have a defined contribution pension, your scheme administrator will usually pay the 25% you owe to HMRC out of your pension. If you have a defined benefit pension, your pension scheme may choose to pay the tax on your behalf but then reduce your pension to cover this cost.

What if I’m near to going over the Lifetime Allowance?

If you’re close to exceeding the Lifetime Allowance, you might want to get advice from a qualified financial adviser. Some people suggest reducing returns on your pension savings, for example, by moving your money into low risk, low return cash holdings so you don’t breach the limit. It’s a highly complex area however, where it will almost certainly pay to get tailored professional advice for your personal circumstances in order to avoid falling foul of the rules and incurring a hefty tax charge.

If you’re not sure how to go about this, or want to see if there might be any other options available to you, you should seek professional independent financial advice. You can find a local financial advisor on VouchedFor or Unbiased.co.uk, or for more information, check out our guides on How to find the right financial advisor for you or How to get advice on your pension.

Did you find this article helpful? We’d love to hear from you at [email protected].

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