The tapered annual allowance was originally introduced from 6 April 2016 - when it was stated the annual allowance would be potentially tapered to a minimum of £10,000 for those with threshold income exceeding £110,000 and adjusted income exceeding £150,000.
From 6 April 2020 the annual allowance taper figures were adjusted to give a higher threshold level of £200,000. The tapered annual allowance calculations will now not affect anyone with a threshold income level below £200,000. However, although adjusted income levels at which taper starts was also increased in 2020 to £240,000, this level again changed in April 2023 and was increased to £260,000 with the minimum taper level also increased to £10,000 (up from the minimum £4,000 level introduced in 2020).
The aim was to reduce the level of pension funding high earners and their employers can make into pension schemes going forward. In this way HMRC are also restricting the high level of pension scheme tax relief they are liable for, either to the individual or the company.
If they exceed the threshold and adjusted income amounts, their annual allowance may be reduced by £1 for every £2 of adjusted income over this level until the minimum annual allowance level of £10,000 is reached.
Threshold income
The idea of the threshold level of income (set at £200,000 for the current tax year) is to ensure that there is some form of certainty for individuals in terms of levels of income and who may be affected, and to ensure this rule does not impact people who have large one-off employer funded pension contributions.
Threshold income is comprised of net income, which is made up (but not exclusively) of:
- income from employment (including any benefits)
- profits from self-employment
- taxable social security benefits
- pensions (including the State Pension)
- savings, dividend and rental income
Net income is defined fully within step 2 of the calculation in section 23 of Income Tax Act 2007. Visit www.legislation.gov.uk for more information.
When calculating net income for tapered annual allowance calculations, you will always deduct personal contributions paid by the net pay arrangement.
- Plus, any income given up by salary sacrifice arrangements entered into post 8 July 2015.
- Minus any personal pension contributions made via the relief at source method (i.e., personal contributions paid net and grossed up by basic rate tax within the pension scheme). This will be a personal pension scheme contribution.
- Minus some allowances (such as tax relief after making a gross RAC contribution) and taxable death benefit lump sums.
If the calculated threshold income is below this level (£200,000 for the current tax year), no further tests need to be carried out and the client can continue to contribute up to the standard annual allowance of £60,000 (current tax year) unless restricted by the Money Purchase Annual Allowance. If, however, after this calculation the income level is more than £200,000 the member will have to undertake the adjusted income test.
Adjusted income
This test is to determine the actual income amount which will be used to determine the appropriate level of annual allowance that a member may use. The income level that triggers the tapering annual allowance is currently £260,000. This income level has been “adjusted“ to take into consideration employee contributions taken from gross pay under the net pay arrangement, employer contributions and salary/bonus sacrifice.
Again there are several factors to take into consideration to determine the level of adjusted income. The calculation is net income, which is made up (but not exclusively) of;
- income from employment (including any company benefits)
- profits from self-employment
- taxable social security benefits
- pensions (including the State Pension)
- savings, dividend and rental income
Net income is defined fully within step 2 of the calculation in section 23 of Income Tax Act 2007. Visit www.legislation.gov.uk for more information.
When calculating net income for tapered annual allowance calculations, you will always deduct personal contributions paid by the net pay arrangement.
- Plus, any claim for excess relief (where the amount of a contribution paid by an individual under a net pay arrangement exceeds the employment income from the individual’s employment or it is not possible for the employer for any other reason to deduct the whole amount of the contribution from the individual’s income – under these circumstances the individual would need to make a stand alone claim for the excess tax relief).
- Plus, any individual contributions made by the net pay arrangement (i.e., where contributions are made via payroll deduction before income tax is paid, therefore giving immediate tax relief). This will be an occupational pension scheme contribution.
- Plus, any UK tax relieved overseas pension contributions.
- Plus, employer pension contributions.
- Minus any lump sum death benefit the individual accrues from another person’s death that is taxable (e.g., benefits on death after the age of 75).
- Minus some allowances (such as tax relief after making a gross RAC contribution) and taxable death benefit lump sums.
In all calculations HMRC have removed the effectiveness of salary and bonus sacrifice to reduce an individual’s level of income. The purpose of this was to prevent employers and employees artificially reducing the level of income they are deemed to have earned to pass the threshold income test and not have to undergo the adjusted income test to see if they will have their annual allowance reduced. Salary/bonus sacrifice is specifically added back in for threshold income calculations although not mentioned at all within the adjusted income calculations. This is because as part of the adjusted income calculation, all pension contributions, including those employer contributions funded by salary sacrifice, are included.
You will note that the calculations for both threshold income and adjusted income take into consideration pension contributions in different ways. By removing relief at source contributions from the threshold income calculation the total income level is reduced down to account for those individuals who have net pay contributions and give a lower salary to be considered. By contrast, should the individual fail the threshold test and must apply the adjusted income test, the calculation is less favourable. Previously the relief at source contribution has been removed to reduce down the level of calculated income, however, here the calculation adds in the net pay contributions and so effectively raises the calculated income.
Example for threshold income
Individual earns £225,000 and via relief at source pension arrangement pays £40,000. This amount would be removed from the individual’s income to give a figure of £185,000.
Example for adjusted income
Individual earns £225,000 and via net pay arrangement pays £40,000. This amount would be added to the individual’s income to give a figure of £265,000. As the client has exceeded the adjusted income level of £260,000, the annual allowance is reduced by £1 for every £2 over £260,000. Here there is an excess of £5,000 so divide by 2 = £2,500. The available annual allowance is now reduced; £60,000 - £2,500 = £57,500.
It is also worth noting that the net income part of the calculations for both the threshold and adjusted income calculations will not include any bond withdrawals that are within the available 5% allowances and will not include collective investment disposals creating a capital gains tax liability. However, any interest and dividends accumulated within a collective will be counted as net income. Also any chargeable gains triggered within a bond will be counted as net income. This will be the full amount of the gain and not a top-sliced gain (for example where applying top-slicing between higher rate and additional rate tax).
If an individual’s annual allowance is reduced due to the adjusted income calculation, it must be remembered that any excess over their lower annual allowance will be subject to the standard annual allowance excess charge. By definition, suffering the tapered annual allowance the individual will be a high earner and as the annual allowance excess charge is based on the marginal rate of tax, this tax liability is likely to be 45% of the excess amount.
Carry forward
The tapered annual allowance rules came into effect from 6 April 2016 and will be calculated and applied each year, applying the threshold and adjusted income limits applicable in that tax year. This may mean that an individual may have different annual allowance levels each year depending on their income for that year. In terms of carry forward, the new annual allowance figures will not affect other years. This will mean that an individual who is looking to carry forward into 2023/24 tax year may have a restricted annual allowance applied for tax year 2023/24 but may still have the full annual allowance available for the previous years.
As an example, for someone who:
- Is not subject to tapered annual allowance in tax year 2023/24 but
- is subject to tapered annual allowance of £12,000 for tax year 2022/23 only and not previous years and
- has been a member of a registered pension scheme for the previous three years but
- has made no pension contributions.
They will be able to fully fund the current tax year to £60,000 and then carry forward unused annual allowance of potentially up to £40,000 from tax years 2020/21, 2021/22 and then the tapered annual allowance of £12,000 from 2022/23.
Please note. The tapered annual allowance calculation will only apply to that specific year. This means that you may have to do this calculation for multiple years. For tax years 2016/17 – 2019/20 the threshold income level was £110,000 and adjusted income level £150,000. For tax years 2020/21 to 2022/23 the threshold income level was £200,00 and adjusted income level £240,000. For tax years 2023/24 onwards the threshold income level is £200,00 and the adjusted income level is £260,000.
For simple examples to explain some of the different situations and how the client may be affected please read Tapered annual allowance examples.
Updated May 2023