Pensions – 2016 annual allowance cut for high earners – a window of opportunity?

Some high income individuals will face a cut in the amount of tax-efficient pension saving they can enjoy from 6 April 2016. This might be the trigger to maximise pension funding this tax year for individuals likely to be affected now or in the future. There’s the possibility of additional funding this year with the introduction of the special £80k annual allowance (AA). Just bear in mind the pending lifetime allowance cut to £1M.

Those with income over £150k can still get 45% tax relief on pension contributions, but their pension saving allowance will be cut from 2016/17.

Who is caught by the 2016/17 AA cut?

The first test (‘adjusted income’)
The standard £40k AA will be reduced by £1 for every £2 of ‘income’ individuals have over £150k in a tax year, until their allowance drops to £10k. So an individual with income of £210k will see their AA cut by £30k (that is, £60k ‘excess’ income divided by 2).

But it’s important to understand what definition of income is used to test whether any allowance is lost. The test uses ‘adjusted income’ in the tax year. This broadly consists of the total of:

  1. The individual’s taxable income, plus
  2. Any personal contributions paid ‘gross’ to an occupational pension, plus
  3. The value of any employer pension contributions for them.

Example 1 – Employer contribution triggers AA cut
Robert has total income of £140k and his employer pays £30k into his SIPP during the 2016/17 tax year.

His adjusted income for the tax year is £170k. As this is £20k over the £150k cap it will reduce his AA by £10k. So for 2016/17 his AA will be cut from £40k to £30k.

The value of employer contributions for a money purchase scheme will be easy to identify. For a defined benefit scheme it is not quite as straightforward. The value added to the individual’s income will be the pension input amount over the tax year less the individual’s own personal contributions.

Defined Benefit (DB) higher earners who are caught won’t have the same scope to adjust their funding levels to remain below their reduce AA and will have to make a choice:

  • Remain in the existing scheme and suffer the tax charge or
  • Leave the DB scheme and perhaps fund up to the reduced AA through a DC scheme.

This decision may hinge on the value of the employer funding that may be lost if they quit the DB scheme.

But not every individual who fails this ‘adjusted income’ test will see their AA cut.

The second test (‘threshold income’)
There’s an additional test which can help some individuals who are caught simply as a result of having pension saving of more than £40k AA in the tax year. Even if their adjusted income exceeds £150k, an individual’s allowance won’t be cut if their ‘threshold income’ is £110k or less for the tax year.

Threshold income is net income from all sources without adding back in any employer pension contributions. Instead any tax relievable personal contributions can be deducted from the individual’s taxable income.

However there are rules to prevent income being manipulated by:

  • Adding back in any employer contributions from new salary sacrifice arrangements started after 8 July 2015.
  • Introducing anti-avoidance legislation to ignore arrangements designed to shift income earned in one tax year but taxed in a different year.

However, there are still ways in which pension contributions can reduce threshold income. Business owners have control over what the company chooses to do with the profits it makes. Making an employer pension contribution into their own pension is not ‘salary sacrifice’. The business owner has not given up salary in exchange for a pension contribution but merely decided to pay themselves a pension contribution out of the company’s pre-tax profits.

Example 2 – employer contribution doesn’t affect AA
Katrina runs her own business and has income of £100k for the 2016/17 tax year. Her company has had a successful year and she decides to make an £80k employer pension contribution into her SIPP by using carry-forward of unused AA from previous tax years.

Katrina’s adjusted income (her ‘real’ income plus employer pension contribution) is £180k. As this is £30k above the £150k cap, it would normally cut her AA by £15k (to £25k).

However, as her threshold income of £100k is below the £110k limit Katrina keeps her full £40k AA.

It isn’t just business owners who can reduce their threshold income by making a pension contribution. Some employees can do it too.

Where someone has employer pension contributions which push them over the adjusted income threshold they can make a personal contribution to bring their threshold income below £110k.

Example 3 – personal contributions restore full AA
Anil earns £120k in tax year 2016/17 and has minimal other taxable income of £2k. He is a member of his employer’s occupational workplace pension, contributing 15% (£18k) which his employer tops up on a 2 for 1 basis (£36k).

Anil’s adjusted income for the year is £158k, so he thinks his AA will be cut……

However, to calculate his threshold income, Anil must deduct his £18k pension contribution from his actual income of £122k. This gives him threshold income of £104k, meaning he keeps his full £40k AA (as it’s below the £110k limit).

The reduced allowance and carry-forward
It will still be possible to carry forward unused allowances to use in a tax year where the standard AA has been reduced. But the available carry forward from a tax year where the annual allowance has been reduced by the taper will be the balance of the tapered amount.

Summary
The adjusted income definition rules could catch many individuals out. It’s easy to overlook the impact of employer contributions and think that they are unaffected if their actual income is below £150k. And an opportunity to boost their funding before the rules come in could be missed.

 

 

 

Source:  Standard Life