Mark Devlin is a member of Prudential's Technical team. He explores how Tapered Annual Allowance can be a tricky path to navigate in terms of planning.
We are now in the second year of the Tapered Annual Allowance and whilst since introduction of this the legislation has not been altered, it can still be a tricky path to navigate in terms of planning.
We have articles in our knowledge centre on the PruAdviser website that will show how this is calculated, additionally our Annual Allowance (AA) Calculator will do the calculations on the taper for you (for this year and last). It's important when looking at clients' financial affairs that the taper situation is checked for 2016/17 and 2017/18 as this will affect carry forward usage. Prior to this, the standard AA of £40,000 will be in effect. The tapered AA will reduce the full AA by £1 for each £2 over the adjusted income limit of £150,000 (as long as threshold income is also above £110,000). It's also important to remember that for those with adjusted income over £210,000 the minimum they will have for this year's Annual Allowance will be £10,000.
To highlight how this works we'll look at a short case study. Michael has an employment contract that states that his salary is £165,000. His employer has a net pay money purchase scheme, Michael contributes £6,000 to this and his employer contributes £12,000.
As the scheme is a net pay arrangement, Michael's total income (for the taper calculation purposes) is actually £159,000 as net pay contributions are deducted before tax becomes payable. So, his tapered AA is £26,500, with total inputs so far of £18,000. Therefore Michael has £8,500 of AA left for the tax year.
At the end of the year Michael's employer makes a pension contribution for him of £8,000.
The issue here is the new employer contribution is included in the taper calculation, changing Michael's adjusted income to £185,000. The knock on effect on his tapered AA, reduces this to £22,500. However, his total AA usage is now £26,000, so an excess of £3,500 exists. There's no carry forward available, resulting in an AA charge of £1,575.
A further complication in this is that mandatory scheme pays can't be used to pay the charge.
You can only call upon mandatory scheme pays if your tax charge is above £2,000 and your scheme inputs for the tax year are above £40,000. So Michael has £8,000 extra in his pension from his employer but it has cost him an extra £1,575. If he extracts this at higher rate tax (including the Pension Commencement Lump Sum (PCLS) and factoring in the AA charge), he will receive £4,025 in his bank account.
A potential solution
Instead of having a £8,000 pension contribution, what if Michael elected to take this as a bonus (increasing his threshold income to £167,000). After deduction of income tax of 45%, and National Insurance of 2%, £4,240 net would be received.
Michael could then make a £3,600 Relief At Source (RAS) contribution to a pension scheme, which is grossed up to £4,500. He would then be able to reclaim £1,125 additional tax relief in his tax return. If we again assume that he extracts this £4,500 from his pension at higher rate tax, he will receive £3,150. On the face of it this would appear to be less of a net benefit, but if you add on the tax reclaim this becomes £4,275, which is marginally more than the employer contribution method. But Michael still has £640 in the bank (the employer bonus payment netted Michael £4,240 and he only had to pay £3,600 to the RAS scheme), so his net wealth is now £4,915. This is a better outcome than the employer paying the contribution.
So in this scenario Michael has fully used up his available tapered AA of £22,500.
But what if in addition to the planning above, Michael had £63,000 of carry forward left?
Making an additional £63,000 gross contribution to a RAS scheme (on top of the £4,500 gross he has already made) would bring his threshold income down to £99,500, therefore one of the two triggers for the tapered AA to apply has not been met. He has regained the full £40,000 for this year (and his personal allowance too). So another £17,500 gross can be made to a pension scheme. Ironically, as he is below the threshold this contribution can be made by his employer!
Tapered AA calculations planning is almost a circular equation to work out what further pension contributions can be made. But it's vital to be aware that changes to any part of the calculation can affect what can be paid.
Given the variables, is aiming to use up a client's AA and carry forward early in a tax year a good idea? Or is now the time at the end of the tax year when the variable should be more locked down?
For more information around tax planning at tax year end, take a look at our tax year end hub.