HM Revenue and Customs impose two controls on the amount of pension savings you can make without having to pay extra tax.
These controls are known as the annual allowance and lifetime allowance. This is in addition to any income tax you pay on your pension once it is in payment.
This guide looks at the annual allowance, which is the amount by which the value of your pension benefits may increase in any one year without you having to pay a tax charge.
What is the annual allowance?
The annual allowance (AA) is the amount by which the value of your pension benefits may increase in any one year without you having to pay a tax charge. This is in addition to any income tax you pay on your pension once it is in payment.
If the value of your pension savings in any one year (including pension savings outside of the FPS) are in excess of the annual allowance, the excess will be taxed as income.
The government reduced the AA from £255,000 to £50,000 from 6 April 2011 and then reduced it again to £40,000 from 6 April 2014.
Further changes to the annual allowance have been made for higher earners from 6 April 2016, which resulted in special transitional rules for the 2015/16 tax year.
These changes are covered in more detail later in this guide.
The current annual allowance limit is £40,000 (unless tapering applies).
Am I likely to be affected by annual allowance?
Most people will not be affected by the AA tax charge because the value of their pension saving will not increase in a year by more than £40,000, or if it does they are likely to have unused allowance from previous years that can be carried forward.
You are most likely to be affected if you:
- have a lot of scheme membership and you receive a significant pay increase
- pay a high level of additional contributions
- are a higher earner
- transfer pension rights into the pension scheme from a previous public sector pension scheme* under the preferential club transfer rules and your salary (full-time equivalent) upon joining the pension scheme is somewhat higher than the salary you earned when you left the previous scheme
- combine a previous scheme pension benefit that was built up in the final salary section of the scheme with your current pension and your salary (full-time equivalent) has increased significantly since leaving and re-joining the scheme
Peninsula Pensions will inform you if your scheme pension savings exceed the standard AA in any year no later than 6 October of the following year.
*A public service pension scheme includes a pension scheme covering civil servants, the judiciary, the armed forces, any scheme in England, Wales or Scotland covering local government workers, or teachers, or health service workers, or fire and rescue workers or members of the police forces; or membership of a new public body pension scheme.
How is the annual allowance calculated?
The increase in the value of your pension savings in the pension scheme in a year is calculated by working out the value of your benefits immediately before the start of the ‘pension input period’, increasing the value by inflation and then comparing it with the value of your benefits at the end of the ‘pension input period’ (PIP).
The PIP is the period over which your pension growth is measured. From 6 April 2016, PIPs for all pension schemes are aligned with the tax year – 6 April to 5 April.
Prior to the 2016/17 the PIP for the scheme was 1 April to 31 March, except for the year 2015/16 when special transitional rules apply.
In the scheme the value of your pension benefits is calculated by multiplying the amount of your annual pension by 16. If the difference in the value of pension benefits at the end of the PIP less the value of your pension benefits immediately before the start of PIP (adjusted for inflation), is more than the AA then you may be liable to pay a tax charge.
It is important to note that the assessment for the AA covers any pension benefits you may have where you have been an active member during the year, not just benefits in the scheme. For example, if the increase in the value of your scheme benefits was calculated as £30,000 in 2014/15 when the AA was £40,000, but you also had an increase in the value of other pension benefits of £15,000 in the same year, that would mean you had a total increase in pension benefits of £45,000.
If you did not have any carry forward (see below for more information), you would be liable for a tax charge for the amount you exceeded the AA by; even though at face value you did not breach the AA in either scheme.
You would only be subject to an AA tax charge if the value of your total pension savings for a year increases by more than the AA for that year.
However, a three year carry forward rule allows you to carry forward unused AA from the previous three years. This means that even if the value of your pension savings increase by more than the AA in a year you may not be liable to the AA tax charge.
For example, if the value of your pension savings in 2014/15 increased by £50,000 (that is, by £10,000
more than the AA) but in the three previous years had increased by £25,000, £28,000 and £30,000, then the amount by which each of these previous years fell short of the AA for those three years would more than offset the £10,000 excess pension saving in the current year. There would be no AA tax charge to pay in this case.
To carry forward unused AA from an earlier year you must have been a member of a tax registered pension scheme in that year.
Changes to annual allowance
The Finance (No 2) Act 2015 introduced two important changes to the AA with effect from 6 April 2016.
- An annual allowance taper for high earners from 6 April 2016
- To adjust the PIP during 2015/16 so that it becomes aligned with the tax year from 6 April 2016
1. Tapered annual allowance for higher earners
From the tax year 2016/17 a Tapered (reduced) AA was introduced. The AA is tapered for members who have both a ‘threshold income’ and ‘adjusted income’ in excess of certain limits.
For every £2 that your adjusted income exceeds the adjusted income limit, your AA is tapered down by £1. The minimum your annual allowance can be tapered down to is the minimum annual allowance.
The threshold and adjusted income limits were increased from 2020/21 and the minimum annual allowance reduced.
The table below confirms the threshold and adjusted income limits, and minimum annual allowance.
|Threshold /adjusted income limits||Definition||Year and limit|
|Threshold income||Broadly your taxable income after the deduction of your pension contributions (including AVCs deducted under the net pay).||2016/17: £110,000
|Adjusted income||Broadly your threshold income plus pensions savings built up over the tax year.||2016/17: £150,000
|Minimum annual allowance||The minimum the annual allowance can be reduced to if your adjusted income exceeds the adjusted income limit.||2016/17: £10,000
Threshold income includes all sources of income that are taxable, for example, property income, savings dividend income, pension income, social security income (where taxable) or state pension income.
Please note, you are not allowed to deduct from taxable income any amount of employment income given up for pension provision as a result of any salary sacrifice made on or after 9 July 2015.
How does the taper work?
Please note that this example applies to the tax years 2016-17 to 2019/20 when the Adjusted income limit was £150,000.
From 6 April 2016, the taper reduces the AA by £1 for £2 of adjusted income received over £150,000, until a minimum AA of £10,000 is reached. This means that from 6 April 2016 the AA for high earners is as follows:
|Adjusted income||Annual allowance|
|£150,000 or below||£40,000|
|£210,000 or above||£10,000|
Gross Salary 2016/17: £120,000
Less employee pension contributions: £13,680
Threshold income 2016/17: £106,320 (below £110,000 so the AA will not be tapered and remains at £40,000)
Pensions saving in the year: £19,500 (less than £40,000 so no tax charge)
Gross salary 2016/17: £130,000
Less employee pension contributions: £14,820
Plus taxable income from property: £30,000
Threshold Income 2016/17: £145,180
Plus pensions saving in the year: £30,000
Adjusted Income 2016/17: £175,180 (greater than £150,000 so AA will be tapered)
Tapered AA: £27,410*
In excess of AA: £2,590 (pension saving of £30,000 less tapered AA)
AA tax charge at marginal rate (assumed to be 40%): £1,036 (£2,590 x 40%)
*Taper = £175,180 – £150,000 = £25,180/2 = £12,590. Standard AA £40,000 less £12,590 = £27,410
Please note, the examples above make no allowance for any carry forward.
2. Aligning the PIP with the tax year
The PIP is the period over which your pension growth is measured. Up until 2014/15 the PIP in the FPS ran from 1 April to 31 March. From 6 April 2016, PIPs for all pension schemes are aligned with the tax year – 6 April to 5 April.
Special transitional arrangements apply for 2015/16 meaning that there are 2 PIPs in 2015/16, as set out below:
Pre-alignment tax year: 1 April 2015 to 8 July 2015 – the revised AA during this period is £80,000
Post-alignment tax year: 9 July 2015 to 5 April 2016 – the AA for this period is the amount of the £80,000 not used up from the pre-alignment tax year (subject to a maximum of £40,000) together with any carry forward available from the three previous years.
How would I pay an annual allowance charge?
If you exceed the AA in any year you are responsible for reporting this to HMRC on your self assessment tax return.
Peninsula Pensions is obliged to notify you if your scheme benefits exceed the standard AA, or we must inform you by no later than 6 October of the following tax year. However, we are not obliged to inform you if you exceed the tapered annual allowance.
If you have an AA tax charge that is more than £2,000 and your pension savings in the scheme alone have increased in the year by more than the standard AA you may be able to opt for the scheme to pay some or all of the tax charge on your behalf. The tax charge would then be recovered from your pension benefits.
If you want the scheme to pay some or all of an AA tax charge on your behalf, you must notify Peninsula Pensions no later than 31 July in the year following the end of the year to which the AA charge relates.
However, if you are retiring (and draw all of your benefits from the scheme) and you want the scheme to pay some or all of the tax charge on your behalf from your benefits, you must tell us before you become entitled to those benefits.
It may be possible for the authority to agree to pay some or all of an annual allowance charge on your behalf in other circumstances, for example, where your pension savings are not in excess of the standard AA but are in excess of the tapered AA, or if the tax charge is less than £2,000.
Am I affected?
If you think you are affected by the AA more information is available on the government’s website
If you are unsure if you will be affected by the AA use the AA quick check tool on the FPS member website.
This guide should not be treated as a complete and authoritative statement of the law.
The rules governing AA can be complex and are subject to change; if you are unsure how to proceed you are advised to obtain independent financial advice. For help in choosing an independent financial advisor visit the money advice website.
If you have any questions about your scheme membership or benefits, please contact us.