Effects of Annual Allowance tapering for high earners
Elaine Turtle, director, DP Pensions presents an example of client confusion that can still surround annual allowance tapering
Effective since 6 April 2016, the annual allowance was reduced for individuals who have ‘adjusted income’ of more than £150,000 a year.
The reduction in the annual allowance reduces by £1 for every £2 someone earns over £150,000, with a maximum reduction of £30,000.
The reduction does not apply to anyone who has a ‘threshold income’ of no more than £110,000.
The definitions of both incomes are needed to understand whether someone is affected by the reduction on pension contributions or not.
Both adjusted and threshold income include all taxable income. But this is not restricted to earnings – it includes all investment income and benefits in kind such as medical insurance premiums paid by the employer.
The difference is; adjusted income includes all pension contributions (including any employer contributions) while threshold income excludes pension contributions.
So let’s look at a situation that happened to one our clients.
Geoff is a company director of an engineering firm – he is the main shareholder – his wife owns a small shareholding and works in the company – but Geoff is the controlling director of the company. Geoff currently takes a salary of £140,000 from the company. Depending on profits he usually makes a pension contribution as an employer contribution when he comes towards his company year-end (30 September).
Geoff had been unaware of this new tapering but he does have a financial adviser, Julie, who he meets with each year early in July to discuss what pension contribution, if any, he will make each year to his SIPP.
So Julie and Geoff met up in July last year to discuss matters. Geoff’s business had a good year so he was looking to make a reasonable contribution to his SIPP – in fact, Geoff wanted to know if he could make more than the £40,000 annual limit, which he was aware of, as last year he had not made any contributions because the business needed funds to purchase new machinery. This year there was no major expense required in the business and with profits good he wanted to know how much he could pay in.
Julie started to explain to Geoff about tapering and about the difference between adjusted income and threshold income. As both of these include all taxable income, any investment income for example, if you have a flat that you rent out, then this rental income counts as income. As well as this adjusted income includes all pension contributions (including employer contributions) but threshold income excludes pension contributions. With threshold income you have to add in any salary sacrifice or bonus sacrifice back into your salary but if you pay any employee contributions you deduct these. So not straightforward.
To complicate matters, HMRC’s definitions of adjusted and threshold income uses ‘net income’ – most of us think of net income as after the tax we pay on our salary. This is not the case here – net income here means income after the deduction of member contributions to an occupational scheme, be it money purchase or defined benefit, under the net pay arrangement. There are other deductions allowed for things like share losses, trade losses and gifts to charities.
Geoff was really confused by now, but could tell Julie his income was £140,000 per annum and he had no other ‘income’ as fortunately the flat he rented out was in his wife’s name and she received the income.
So Julie went through the numbers, if Geoff was to make an employer contribution to his SIPP of £40,000, this would make his adjusted income £180,000 and his threshold income would be £140,000, so taper relief does apply. Based on adjusted income of £180,000 if the £40,000 was paid by the company to his scheme he could actually only have £25,000 paid on his behalf.
Geoff understandably was disappointed in this and found it very confusing. Julie explained as he had not paid maximum contributions into this scheme in previous years he would be able to use carry forward to make a bigger contribution using the lack of maximum contributions in previous years. Going forward he would be affected due to his high income.
Julie calculated Geoff’s carry forward ability and the company could pay £30,000 in for him after paying the maximum in this tax year of £25,000 so he could in total pay £55,000 or stick to the £25,000 for this tax year and pay another £15,000 to bring him up to £40,000.
Geoff said he wanted to think about things and would come back to Julie, he was grateful to Julie for explaining everything regarding how much could be paid, because without meeting up with Julie, he would have remained completely unaware of the new situation on contributions to his scheme.
Julie did remind him that his wife did work for the company as well as being a shareholder and her income was much lower and she did have a personal pension plan to which the company contributed 5% of her salary. Even with the rental income she was receiving, this made her income under £100,000, so the company could make a contribution to her pension as well to Geoff’s pension.
Geoff called Julie a week later and said they had decided to make the £25,000 to Geoff’s SIPP and also make a £40,000 contribution to his wife’s personal pension. So in total the company was making £65,000 in pension contributions.
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