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Member contributions - tax relief and annual allowance
Key facts
- Tax relief is based on tax years.
- Annual allowance is based on pension input periods.
- Tax relief is limited to contributions up to the higher of £3,600 per tax year or 100% of earnings.
- Member contributions are unrestricted although a tax charge applies on contributions above the annual allowance.
- Investment income and dividends don’t count as relevant UK earnings.
- Three main methods in giving tax relief; relief at source, net pay arrangement, and relief on making a claim.
- Any contributions over the annual allowance available attract a tax charge.
How much tax relief is given?
Tax relief is calculated in tax years. In any tax year tax relief is only given on gross contributions of up to £3,600 or 100% of relevant UK earnings, whichever is the higher. Looking at two examples, a member with no relevant UK earnings can get tax relief on a contribution of up to £3,600 whereas a member with relevant UK earnings of £25,000 can receive tax relief on contributions up to £25,000.
What are relevant UK earnings?
In short this is:
- employment income,
- self-employed income,
- income from patent rights,
- certain redundancy payments,
- earnings from overseas crown employment.
This means that salary counts as relevant UK earnings, but investment income and dividends don’t. This can have implications for controlling directors in deciding whether to make a pension contribution as a member or an employer contribution.
Redundancy payments
Only part of a redundancy payment counts as relevant UK earnings. A redundancy payment can be made up of the actual redundancy payment and other payments such as salary, payment in lieu of notice or holiday pay. Any part of a lump sum redundancy payment that comes from salary, payment in lieu of notice or holiday pay does count as relevant UK earnings. However, only the part of the actual redundancy payment over the tax-exempt threshold of £30,000 will be classed as employment income and therefore count as relevant UK earnings.
Let’s look at an example where a member receives a lump sum payment on redundancy that’s made up as follows:
One month’s salary - £2,500
One month’s salary in lieu of notice - £2,500
Holiday pay - £750
Redundancy payment - £31,250
Total - £37,000
The first three items all count as relevant UK earnings. In addition to that, £1,250 of the redundancy payment is also classed as relevant UK earnings.
How is tax relief given?
This depends on what type of pension scheme we’re talking about. There are three main methods and these are shown in the following table:
| Type of pension scheme | Method | How does the tax relief work? | What about higher rate tax relief? |
|---|---|---|---|
| Personal pension (including Stakeholder) | Relief at source (RAS) |
|
|
| Occupational pension scheme | Net pay arrangement |
|
|
| Occupational pension scheme/retirement annuity contract | Relief on making a claim |
|
|
Further details of how higher rate tax relief is given can be found in Member contributions and higher rate tax relief.
The annual allowance
The annual allowance is the total amount of contributions that can be paid into all pensions for a member before a tax charge applies. This allowance applies to all member contributions, employer contributions and contributions for the member paid by a third party (e.g. grandparent).
The annual allowance is not calculated in tax years, it is based on contributions paid during a a period of time called a pension input period. More details of pension input periods can be found in Understanding pension input periods.
For pension input periods ending in the 2012/13 tax year the annual allowance is £50,000. There’s a tax charge on any contributions paid over the annual allowance in each year. This is called the annual allowance charge and is calculated at the member’s marginal tax rate. Any potential tax charge is dealt with through the member’s tax return.
To see if an annual allowance charge applies the total amount of contributions paid in the pension input period needs to be calculated.
It’s important to remember that the annual allowance and tax relief work separately from one another. This means that it’s possible for some contributions to receive tax relief but for an annual allowance tax charge to also apply. Let’s take a look at how this works in the current tax year:
Member’s relevant UK earnings - £60,000
2012/13 annual allowance - £50,000
Member receives tax relief on gross contributions up to £60,000
Annual allowance charge on (£60,000 - £50,000) = £10,000
All of the excess contribution lies in the amount of taxable income taxed at 40%, so the amount of the charge will be 40% of £10,000 = £4,000.
To avoid double taxation, only contributions that receive tax relief count towards the annual allowance. If a member’s UK relevant earnings are £70,000 and they make a gross contribution of £80,000 to their plan, they’ll only receive tax relief on £70,000 and therefore would face a tax charge of 40% on the amount above the annual allowance, which in this case is £20,000.
Does this mean everyone can get tax relief on contributions up to £50,000?
No, the tax relief limits for member contributions haven’t changed. To get tax relief the total gross member contributions still have to be within the higher of 100% of relevant UK earnings in the tax year and £3,600 p.a. What the annual allowance does is place a limit on the amount of tax relief a member can receive.
For defined contribution schemes, the pension input amount is simply the total of all gross contributions. If the pension input amount exceeds the annual allowance, an annual allowance charge is payable on the excess via the member’s tax return. So if Sally has UK earnings of £60,000 and tax relief is given by the relief at source method, she can pay a net contribution of up to £48,000. The provider will gross this up to £60,000 and claim the £12,000 basic rate tax relief from HMRC. Sally will then claim higher rate tax relief through her tax return but will also have to declare that her pension input amount is £10,000 over the annual allowance. A tax charge equal to her marginal rate of tax will be levied, effectively removing all tax relief from the excess contributions.
How does this work with employer contributions?
The tax relief rules for employer contributions haven’t changed. If they meet the ‘wholly and exclusively’ conditions the employer can claim corporate tax relief in respect of them. Employer contributions count towards the annual allowance and if that results in contributions of over £50,000 being paid in respect of a member an annual allowance charge will be payable by the member.
Does the annual allowance operate over the tax year?
No, it operates over the pension input period, which in most cases won’t align with the tax year. That means that member contributions have to pass two tests if they are to receive tax relief and avoid triggering a tax charge.
Firstly, contributions paid in the tax year have to be within the 100% of earnings/£3,600 limit in order to receive tax relief. Secondly the contributions paid over the current pension input period have to be within the annual allowance available to avoid the annual allowance charge.
It’s possible to close a pension input early. This could be done to align the pension input period with the tax year. New plans set up after 6 April 2011 will automatically align with the tax year unless a different end date is nominated. See Understanding pension input periods.
What about contributions to an occupational pension scheme?
If the scheme is a defined contribution scheme, the pension input amount is the total gross contributions as explained above.
If the scheme is a defined benefit scheme it isn’t quite as straightforward. For these schemes, the amount of pension accrued over the pension input period for the member has to be calculated and valued using a factor of 16. See Understanding pension input periods.
If a member hasn’t paid the maximum tax relievable contribution in previous tax years can they use carry forward to pay contributions higher than 100% of earnings in this tax year?
No, it’s unused annual allowance that’s being carried forward, not unused tax relief. If Sally in the example above had unused annual allowance of at least £10,000 to carry forward, she could avoid the annual allowance charge. However if she had paid less than 100% of her earnings in previous years, that unused tax relief couldn’t be carried forward to justify tax relief on member contributions of more than £60,000.
Further information on the annual allowance can be found in Contributions & allowances. We’ve also written about the new restrictions that came into effect from April 2011.
Updated 6 February 2012
Notes
The information provided is based on our current understanding of the relevant legislation and regulations and may be subject to alteration as a result of changes in legislation or practice.
Any research and analysis has been provided by us for our own purposes and the results of it are being made available only incidentally.
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