From 6 April 2016, the amount that can be contributed into an approved pension scheme each year (ie the annual allowance) for tax relief purposes has been reduced from £40,000 to just £10,000 for individuals whose ‘threshold income’ exceeds £110,000 and ‘adjusted income’ is more than £210,000 per tax year.
Threshold income – is all earned and unearned income (eg rental income and other investment income) on which income tax is charged. In calculating threshold income, a deduction is made for any employee pension contributions, but any income given up in a salary sacrifice arrangement entered into after 8 July 2015 must be added back.
Adjusted income –is an individual’s threshold income with pension contributions (both employees and employers) paid during the tax year added back. If the adjusted income exceeds £150,000, the annual allowance is reduced by £1 for every £2 that the adjusted income exceeds £150,000 to a minimum of only £10,000 per tax year.
Key points to be aware of are as follows.
- Pension contributions in excess of the annual allowance result in a tax charge at your marginal rate of income tax on the excess.
- Any unused annual allowance from the previous three tax years can be used to temporarily maintain higher pension contributions as these new rules start to take effect.
- One-time payments (eg bonuses or equity gains) may increase threshold and adjusted income, and impact the amount of pension contributions that can be made before tax charges apply.
How does this impact employers?
Employers should advise all existing and new higher earning employees about the implications of the changes. This can be a challenging conversation as it may offer flexibility to a certain group of employees that does not extend to the entire workforce.
Adjustments to employer pension contributions impact an employee’s total reward package and this has led to employees demanding cash in lieu of pension contributions. This will increase the cost to the employer, as the cash payment will be subject to employers’ national insurance contributions (NIC) at 13.8 per cent.
The implications of the changes may also have employment law consequences.
Charlie earns a salary of £200,000 and a bonus of £50,000. Charlie makes a pension contribution of 10 per cent of his basic salary which his employer matches. Charlie has no brought forward unused annual allowance.
Scenario 1: Charlie’s tax relievable pension contributions is restricted to £10,000, but a total contribution of £40,000 has been made. Therefore, the excess attracts a tax charge of £13,500 (£30,000 @45 per cent) and the benefit to Charlie of his employer’s contribution, like his own contribution, is only £13,250 (£20,000 - £6,750) .
Scenario 2: Charlie agrees with his employer to reduce his pension contribution to £5,000 and his employer also pays £5,000. There is no excess contribution or tax charge.
In Scenario 1, the cost to both Charlie and his employer is £15,000 more than in Scenario 2, but Charlie only benefits by an extra £8,250 in each case.
The new pension rules restrict the amount that may be saved in to a pension scheme tax efficiently and hence, it is now more important than ever to plan carefully for retirement savings to avoid incurring unnecessary tax charges. This may mean that employers need to consider alternative arrangements.