Understanding the Annual Allowance

This is likely to be of relevance to anyone studying for one of the CII’s general pensions exams such as R04 or J05.

This article is relevant to examinable tax year 2022/23.

The annual allowance was first introduced as part of the pensions simplification changes on A-day. For those too young to remember, this was 6 April 2006, and the purpose was to simplify the tax treatment of defined contribution pensions by amalgamating several different regimes which were of relevance to different products. It basically introduced a limit to the level of tax relievable pension contributions which were allowed to be made by, or on behalf of, an individual member during any one tax year.

It’s fair to say that since then, the allowance has been subject to some fairly brutal cuts as various governments look to claw back some tax revenue. From a starting point of £215,000 in the 2006/07 tax year and a high of £255,000 during the 2010/11 tax year, it has now been cut to just £40,000 per annum.

Historically, there was an exemption from the annual allowance which allowed members to input as much as they wished in the tax year of retirement. That, too, has now been stopped, and the only exemptions from the annual allowance test are pension input in the year of death and input in the year that a member takes early retirement due to serious or severe ill-health.

Calculating Pension Input

So how is pension input calculated? For a defined contribution scheme, it is very simple. The pension input is simply the gross value of all contributions made to the scheme during the tax year, be that by the employer or the employee.

For defined benefit schemes, it is slightly more complex. We basically need to calculate the capitalised value of the scheme benefits at the start of the year. This is derived by working out the annual pension payable, multiplying it by a factor of 16 and adding any separately payable lump sum. We do NOT count lump sums paid by commutation of the income benefits. We then need to carry out the same calculation for the value of the benefits at the end of the year, increase the starting value in line with inflation and work out the difference between the two to give the pension input.

Carry-Forward

Legislation does allow scheme members to carry forward unused allowance from the previous three tax years, provided they were a member of a relevant pension scheme during the tax year in question. However, in order to take advantage of this, the current year’s annual allowance must first be utilised in full. Carry-forward can then be utilised for each year in chronological order, i.e. the earliest years first.

UK Earnings Restriction

One factor which tends to catch people out, however, is the relevant UK earnings restriction. As we know, pension contributions are tax relievable. This rule basically provides that no scheme member may make tax relievable pension contributions to a UK pension which exceed their relevant UK earnings for that year.

So, for example, if a member’s salary was £30,000 then they cannot personally contribute more than this and so cannot use carry-forward to do so, regardless of whether they have used their annual allowance for previous tax years in full or not. This can be a headache when advising a client on undertaking pension planning. Note that this does NOT apply to employer contributions, which are only limited by the annual allowance and any available carry-forward.

Where the pension input during the tax year exceeds the annual allowance plus carry-forward (or, if applicable, where it exceeds relevant UK earnings) a tax charge is levied. This is basically calculated by establishing the amount by which pension input exceeds the limit and adding this amount to the member’s taxable income for the year as if it were earned income. This effectively removes the tax relief provided and removes any incentive to make excess pension contributions.

For a defined benefit scheme, it is usual for members to make some contributions, even though the actual value of their benefits will be determined by length of service, earnings and accrual rate rather than the amount they have input. Interestingly, in this situation, the overall pension input calculated above is considered an employer contribution and as such eligible to be tested against the full annual allowance, even if this exceeds relevant UK earnings. However, member contributions are considered personal contributions and as such cannot exceed relevant UK earnings.

Note, this is before you take into account additional complications such as the tapered and money purchase annual allowances. It’s enough to confuse the experts, never mind the clients.

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