- The tapered annual allowance was introduced from 6 April 2016.
- For the taper to apply, the limits on threshold income and adjusted income must both be exceeded.
- For every £2 of adjusted income over £150,000, an individual’s annual allowance is reduced by £1.
Why the tapered annual allowance was introduced
In an attempt to control the cost of pensions tax relief and help make sure pensions tax relief is fair and affordable, from tax year 2016/17, a reduced annual allowance may apply to all pension savings by or on behalf of a member, depending on their level of taxable income within the tax year.
On 6 April 2016 the government introduced the Tapered Annual Allowance for individuals with “threshold income” of over £110,000 AND “adjusted income” of over £150,000.
Where an individual has a “Threshold income” of £110,000 or less they cannot be subject to the tapered annual allowance and there is no requirement to calculate adjusted income. If threshold income exceeds £110,000 you must calculate adjusted income to work out the amount of any tapered annual allowance.
The threshold income measure helps to provide certainty for individuals with lower salaries who may have one off spikes in their employer pension contributions. If the individual’s net (taxable) income is no more than £110,000 they will not normally be subject to the tapered annual allowance. However, anti-avoidance rules will apply so that any salary sacrifice for pension savings set up on or after 9 July 2015 will be included in the threshold income calculation.
“Threshold Income” is broadly defined as ‘the individual’s net income for the year’. This will include all taxable income such as, salary, bonus, pension income (including state pension), taxable element of redundancy payments, taxable social security payments, trading profits, income from property (rental income), dividend income, onshore and offshore bond gains, taxable payment from a Purchased Life Annuity, interest from savings accounts held with banks, building societies, NS&I and Credit Unions, interest distributions from authorised unit trusts and open-ended investment companies, profit on government or company bonds which are issued at a discount or repayable at a premium and income from certain alternative finance arrangements etc, less the amount of any taxable lump sum pension death benefits paid to the individual during the tax year that can be deducted from the threshold income.
For the process to calculate threshold income see Steps 1 and 2 of “The process for calculating adjusted income” detailed below.
In summary “threshold income” is:
- Taxable income for the tax year less
- Any taxable lump sum pension death benefits accruing in the tax year plus
- Employment income given up for pension contributions (i.e. salary sacrifice) under an arrangement made on or after 9 July 2015 less
- The gross amount of any relief at source pension contributions (to ensure that when calculating threshold income, there is parity between any contributions made under net pay, which are deducted arriving at taxable income, and relief at source).
The ‘adjusted income’ definition adds in all employer pension contributions, to prevent individuals from avoiding the restriction by exchanging salary for employer contributions. For those in defined benefit or cash balance arrangements, the value of the employer contribution will be calculated using the annual allowance methodology. That is the employer contribution will be the total pension input amount for the arrangement, less the monetary amount of any contributions made towards that arrangement by the member during the tax year.
The process for calculating adjusted income
1) Identify the amounts of income on which the taxpayer is charged to income tax for the tax year. The sum of those amounts is “total income”. Each of those amounts is a “component” of total income (components of this income will include all taxable income as covered previously).
2) Deduct from the components the amount of any relief under a provision listed in relation to the taxpayer in section 24 to which the taxpayer is entitled for the tax year. See section 25 for further provision about the deduction of those reliefs. The sum of the amounts of the components left after this step is “net income“.
3) Add the amount of any pension contributions:
- Under Net pay arrangements
- Gaining UK tax relief but made to overseas pension schemes
- Using Excess relief under net pay provisions
- Using relief on making a claim provision
4) Add the value of employer contributions, which are:
- Money Purchase = value of contributions
- Defined Benefit = Pension Input Amount minus member contributions (technically you have to add in the total pension input amounts and subtract the member contributions but this amounts to the same thing and is simpler)
5) Subtract the amount of any taxable lump sum pension death benefit paid to the individual in that tax year
How the taper works
Where both the adjusted income and threshold income have been breached then the rate of reduction in the annual allowance is by £1 for every £2 that the adjusted income exceeds £150,000, up to a maximum reduction of £30,000, down to a minimum tapered annual allowance of £10,000.
This results in an Annual Allowance of £40,000 for those with an adjusted income of less than £150,000; a reducing Annual Allowance for those with adjusted incomes between £150,000 and £210,000 and an Annual Allowance of £10,000 for those with an adjusted income over £210,000.
The Tapered Annual Allowance limits apply to both Defined Contribution and Defined Benefit pension input amounts. Although the value of “contributions” is easily identifiable within Defined Contribution type schemes, it is not as straight forward with Defined Benefit schemes. However, an example of the DB calculation method is below:
Calculation for a Defined Benefit pension input amount
The assumed basis for calculating a defined benefit pension input amount in this example is a 1/60th accrual scheme, and CPI of 3%
15 years’ service
£75,000 pensionable earnings; increasing to £78,000
Money purchase AVC contributions £4,680
Step 1 – ‘Opening Value’:
(15/60 x £75,000) x 16
= £18,750 x 16
Step 2 – Increase ‘opening value’ by inflation:
£300,000 x (1 + 3%)
Step 3 – ‘Closing Value’:
(16/60 x £78,000) x 16
= £20,800 x 16
Step 4 – DB ‘Pension Input Amount’:
Closing Value – Opening Value
= £332,800 – £309,000
Step 5 – Add money purchase contributions:
£23,800 + £4,680
Total pension input amount = £28,480
Those subject to a Tapered Annual Allowance will still be able to carry forward unused allowance from the previous three tax years.