Annual Allowance

Everything you need to know (almost!)

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Pension tax (Annual Allowance 2020/21 tax year)

Just when you’re getting to grips with your company pension scheme, there’s always someone who goes and spoils it by mentioning the dreaded t-word… or tax, as it’s affectionately known. Fortunately, unless you’re juggling multiple assets and offshore investments, it’s not as complicated as you might think. The important thing is to keep an eye on your annual allowance.

What is your annual allowance?

One of the perks of putting money into any kind of pension scheme is that it’s tax-free… up to a point. The only downside is that there is a limit on how much you can save before HMRC starts to take its share. This limit is called your annual allowance (AA).

Your annual allowance is currently set at £40,000 for the majority of members. This is the maximum amount of money you can build up each year across all of your pension schemes – including salary deducted contributions, employer contributions and any additional private pensions you may have.

How is your annual allowance calculated?

This is where it gets a little complicated. Rather than just adding up how much you and your employer pay into your company pension, your annual allowance contribution is calculated by working out the change in value of your pension benefits over the course of the year. This is done by:

  1. Multiplying the growth in the value of your pension by 16
  2. Adding on the value of any automatic lump sum you might be entitled to with your pension
  3. Adding on any AVCs that you or your employer have paid in during the year

The same calculation is carried out at the beginning and the end of the financial year (April 6 – April 5) with an appropriate adjustment included for inflation. The difference between the two amounts is what goes towards your annual allowance.

For example, if your pension is worth £10,000.00 at the start of the year.

Start of year

£10,000.00 x 16 = £160,000.00

£4,000.00 + lump sum = £4,000.00

End of year

£12,000.00 x 16 = £192,000.00

£4,500.00 + lump sum = £4,500.00

+ AVCs = £5,000.00

The values at the start of the year are adjusted to allow for CPI and the difference between the two years = £34,220.00

The amount of your annual allowance used up = £34,220.00 (+ any private pension contributions).

If maths isn’t your thing, don’t worry – we always work out your contributions throughout the year and whenever you get close to (or over) your annual allowance limit, we write to you and let you know.

What if you exceed your annual allowance?

In some ways, it’s a nice problem to have, but if you do have more than £40,000 pension savings in a single year, you will have to pay an annual allowance Charge (AAC). This is worked out in the same way as your income tax, so anything over the £40,000 limit is effectively taxed as though it were additional salary.

The good news is that you are allowed to bring forward any unused allowances from the previous three tax years. So, if you do have one bumper year, it is possible to reduce your annual allowance charge or avoid it completely.

Does transferring your pension impact your annual allowance?

When you transfer to an LGPS, Police or Fire pension from a scheme which isn’t LGPS, Police or Fire, it can sometimes have an impact on your annual allowance – especially if you’ve had a salary increase along the way. But there shouldn’t be too many surprises. Here’s how we calculate your annual allowance in that first year:

  • We don’t include the value of any transferred pension benefits
  • We don’t include any actuarial adjustments
  • We do include the effect of a salary increase
  • We do include any increase in final salary benefits

Transfer from another LGPS, Police or Fire scheme

If you have transferred service from another LGPS, Police or Fire pension provider, HMRC will treat that pension accrual as the same arrangement and unused allowance and salary links will remain from your previous arrangement.

What is a tapered annual allowance?

While the annual allowance for most people is £40,000, this limit is reduced (tapered)for high earners. So, if your ‘threshold income’ is greater than £200,000 or your ‘adjusted’ income is greater than £240,000., you don’t enjoy the same amount of tax relief on your pension.

Threshold income = Total Income pension contributions death benefits from other pension schemes Adjusted income = Total income + pension growth/PIA not pension contributions any death benefits

A tapered annual allowance works on a sliding scale, so the more you earn, the less tax relief you receive.

Tapered annual allowance

Total adjustable incomeAnnual allowance
£240,000£40,000
£250,000£35,000
£260,000£30,000
£270,000£25,000
£280,000£20,000
£290,000£15,000
£300,000£10,000

If you’re forced to retire early on health grounds, you may be able to claim a full pension without any reductions (known as a tier 1 or tier 2 pension). These enhanced benefits can sometimes lead to annual allowance charges in your final year of employment – but there are exemptions if you meet HMRC’s severe ill health criteria. For more information, visit the Gov.uk website

Does ill-health retirement affect your annual allowance?

If you’re forced to retire early on health grounds, you may be able to claim a full pension without any reductions (known as a tier 1 or tier 2 pension). These enhanced benefits can sometimes lead to annual allowance charges in your final year of employment – but there are exemptions if you meet HMRC’s severe ill health criteria. For more information, visit the Gov.uk website

Paying your tax bill

Parting with your hard-earned cash

You’re probably not be too thrilled about having to pay tax on your pension, but if you have received an annual allowance charge there’s no point making it more stressful than it needs to be. The following information will help you cut through the clutter when it comes to making the payment.

If you owe less than £2,000

If your annual allowance charge is less than £2,000, you should pay it directly to HMRC as part of a self-assessment tax return. The deadline for this is 31 January (the following year).

If you owe more than £2,000

If your annual allowance charge is more than £2,000, we can usually pay it on your behalf out of your pension fund. This is done through our Scheme Pays facility.

What is Scheme Pays?

Scheme Pays is a way of paying some or all of your annual allowance charges out of your pension savings. Rather than asking you to pay HMRC directly, we make the payment on your behalf and reduce your pension fund to cover the cost. This works in one of two ways:

Mandatory Scheme Pays

As the name suggests, this is a compulsory payment method for anyone who meets ALL three of the following conditions:

  • Your LGPS, Police or Fire pension savings are in excess of £40,000
  • Your annual allowance tax charge from your LGPS, Police or Fire pension scheme is over £2,000
  • Your Scheme Pays deduction applies exclusively to your LGPS, Police or Fire scheme

If you use the Mandatory Scheme Pays facility, you and your LGPS, Police or Fire pension fund are jointly liable for meeting HMRC’s payment deadline of 31 January (the year after the tax charge).

Voluntary Scheme Pays

This is an optional payment method for anyone who wants to pay their annual allowance charge out of their pension savings, but doesn’t meet the criteria of the Mandatory Scheme Pays. It typically relates to people who are affected by the reduced (tapered) annual allowance.

If you use the Voluntary Scheme Pays facility, you are solely liable for meeting HMRC’s payment deadline of 31 January (the year after the tax charge).

If you want to use Scheme Pays, you will need to complete a form, which is available via our helpline or by emailing askpensions@localpensionspartnership.org.uk. Just be aware that once you’ve signed and returned this form, you can’t change your mind.

For more information, contact your LPPA helpline on 0000 000 000

Your annual allowance statement

Good news travels fast

If you receive a letter from us, which includes your annual allowance and Pensions Savings statement, it’s probably because you’re over your limit or very close. Please read the contents carefully, as it will outline exactly where you’re up to and what, if anything, you need to pay.

What to do next?

We understand that these types of letters can often leave you scratching your head. Unfortunately, as your pension administrators, we are not regulated to offer tax advice, which means we are limited in the support we can provide.

We can answer questions about the contributions listed on your statement or the Scheme Pays facility. We can also check your records if you think you have exceeded your annual allowance and haven’t received a letter. But if you do need advice on your personal tax situation, you must speak to a professional adviser.

Where to get tax advice?

If you don’t have a financial adviser or a professional tax adviser, websites such as www.unbiased.co.uk may be able to help you find a suitable candidate. Personal recommendations are also worth considering. Alternatively, the links below include up-to-date information that you might find useful.

HM Revenue & Customs website

The Pensions Advisory Service (TPAS)

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