Pension Allowance Taper

A chosen ewe of two years old they pay To Ceres, Bacchus, and the God of Day

There was a good to fair chance of me hitting George Osborne’s pension allowance taper this year, so I spent the last couple of months trawling the internet, looking for ways to avoid this eventuality.

The results were mixed

The good news is that I can keep my pension allowance at £40,000, probably for the last time. The bad news is that I’ll have to pay more NI than I would’ve if George had not been inspired to meddle with pensions in the first place.

Here’s how it used to work.

  • My employer’s pension plan is non-contributory. They pay a percentage of my salary into my pension regardless of whether I choose to contribute myself.
  • On top of that, I can salary sacrifice whatever I like – as a lump sum or a monthly payment – into the company pension from my pay, and my employer will chuck in an additional 7.5% of the amount sacrificed. Because: ‘ee NI is 2% and ‘er NI is 13%, which is 15% in total, divide that in half and you get 7.5%.
  • For every pre-tax £100 I salary sacrificed into my pension I had £107.50 paid into the plan.
  • Naturally, each year I would salary sacrifice whatever I could in order to get the 7.5% uplift. Then I would transfer that amount from the company pension into my SIPP. Because: lower fees.

Enter George G. O. Osborne. Things become complicated.

Those whom George considers to be “high earners”[1], now have their £40,000 pension allowance tapered down to £10,000 if their adjusted income exceeds £150,000. BUT only if their threshold income is more than £110,000. Mechanically pension allowance taper works the same way as the personal allowance taper for incomes over £100,000: for every £2 of income over the limit you lose £1 of the allowance. Does that sound unnecessarily complex? That’s because it is, and wait till you hear more.

Threshold income

My threshold income is as follows[2]:

  • My net income (which includes my salary, bank interest, SAYE dividends and P11D benefits); plus
  • Any salary sacrifice I make into my pension (since the arrangement is flexible, it’s caught by the anti-avoidance clause); minus
  • The gross amount of my SIPP contributions.

The last point is key: if I make pension contributions via salary sacrifice, then they are part of my threshold income, but if I make a personal contribution into the SIPP where tax relief is given at source, then that amount is excluded from my threshold income. Of course, by doing so I lose the 7.5% uplift I would have received from the company and I have to pay 2% employee NI.

Each £100 of pension allowance I keep by claiming relief at source costs me £19 (I have to forgo £200 of salary sacrifice given the 1:2 taper), but its value to me is the £15 tax deferral and £25 tax saving[3]. So the differential benefit is at least £6.

Adjusted income

My adjusted income is[2]:

  • My net income (same as above); plus
  • Any salary sacrifice I make into my pension (same as above); plus
  • Any pension contributions my employer makes;

In my case the difference between adjusted income and threshold income is pension contributions – my own, paid into the SIPP, and my employer’s, paid into the company plan. Pension contributions made as salary sacrifice are included in both.

Bad laws badly written

It annoys me how poorly drafted the rules are. The whole thing is rife with contradiction and confusion. Let’s take the definition of net income. The HMRC website states that the net income is taxable income less any reliefs. You’d think this would mean gross income less personal allowance, dividend allowance and personal savings allowance, which would be consistent with the verbiage in the self assessment tax return, where total income on which tax is due equals total income minus personal allowance.

But no, it does not. Net income is in fact gross income: your personal allowance doesn’t enter the calculation, neither does the £5,000 dividend allowance, nor the personal savings allowance. So if your income is more than £150,000, the interest and dividends you receive in taxable accounts – even if the amount received is less than the tax free limit – reduce your pension allowance due to the taper. It would be nice if the HMRC Pensions Tax Manual made this clear.

Another thing that strikes me as inconsistent is that rental income is included net, i.e. after subtracting allowable deductions. I can’t claim platform fees against my SAYE dividends, but a buy-to-let investor can deduct property expenses from the rent he receives. As an aside, rent-a-room scheme is looking increasingly attractive: £7,500 p.a. tax free AND it doesn’t impact the pension allowance by the virtue of being tax exempt and hence not part of the net income.

One last time

My past disregard of all matters Personal Finance has endowed me with some carried forward pension allowance, which is the sole reason I can avoid the blasted taper this year. I’m over the limit on adjusted income, but my threshold income is under the £110,000 mark. Next year … unlikely, but we shall see.

I never thought I’d say this, but at least I don’t have a DB pension. From what I’ve glimpsed on the DB plans, the rules there appear even more confusing.

Guides and tools

Below are some resources I found useful.

As per usual, reader beware: I have gathered only what I deemed applicable to my current situation. The reference list is not intended to be complete, nor can I vouch for the accuracy of any of the materials.

A few words on the subject of LISAs

If in future my pension allowance is reduced, I may have to open a LISA account. That’s annoying because a LISA isn’t as good a deal to a higher rate tax payer as the pension.

Example 1:

A higher rate taxpayer wants to save £100 of his pre-tax income into a pension at the age of 39, and earns a 5% annual return until he retires at 58 (let’s ignore NI).

In 19 years’ time his pension will be worth £100 x 1.05 ^ 19 = £252.70. A quarter of this can be withdrawn tax free. The rest of it can also be withdrawn tax free, provided he keeps his annual pension drawdown within his personal allowance. This shouldn’t be very difficult, as any tax free income from his ISAs can be used to supplement the pension income. With no mortgage and living modestly, he doesn’t need to pay much (or even any) income tax post-retirement.

Example 2:

A higher rate taxpayer wants to save £100 of his pre-tax income into a LISA at the age of 39, and earns a 5% annual return until retiring at 58.

In 19 years’ time his LISA will be worth £60 x 1.25 x 1.05 ^ 19 = £189.52. This is tax free, but so what? If he’s living modestly and has tax-free income from other ISA products, that’s a waste of his personal allowance.

Also, LISAs don’t have the same protections as pensions, e.g. in case of bankruptcy, and they will count as “savings” if you ever need to claim unemployment benefits. Granted, the possibility seems is remote, and having other ISA products renders it a moot(ish) point. Still, one can never be sure.  

LISAs weren’t brought in for the benefit of the people – they were brought in so that HM Treasury can get more tax revenue sooner. If I were a conspiracy theorist, I’d say the additional complexity and confusion that the taper rules introduced to pensions were part of Osborne’s plan. But I am not. And I don’t think they were.

I think the hurried, badly written legislation, which has turned an already complex area into a multi-layered clusterfuck of convoluted rules, guidelines and definitions, really was the best he could do. George Osborne simply wasn’t a good Chancellor.

Notes:

  1. With no differentiation between the cost of living in London vs the rest of the country.
  2. There are more things to take into account, which are not relevant to me. The full list can be found on the HMRC website.
  3. I don’t expect to pay 40% tax after I retire, so ignoring any investment return and assuming tax rates don’t change, the tax I’ll pay on the £100 when I start drawing my pension is £100 x 75% x 20% = £15.
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16 thoughts on “Pension Allowance Taper”

  1. Hi
    interesting article.

    There may be a couple of advantages of a LISA as I understand it – 1. they dont count as part of the lifetime allowance for pensions, so if your pension pot is likely to reach the lifetime limit you can put your money into a LISA and still receive the tax relief, assuming you wont need your money till you are 60, and 2. you can withdraw the LISA in full, tax free at the age of 60 if you want.

    Cheers

    Like

  2. Hi 365,

    Welcome to madness 🙂 It took me a while to work my way around all of this, and I use a Financial Advisor who helps to calculate everything along this for me (all included in the fees he takes from my regular drip feed).
    It is a real pain trying to calculate, especially if you get a bonus in your March pay cheque you have very little time to work out what your adjusted income is, what that does for your tapering, and therefore what you can put into your pension. Not to put it too finely, its a bloody nightmare!
    This is where you seriously have to start looking at how best to invest to avoid income (hence I overpay my mortgage rather than say buy VWRL in a non tax efficient wrapper).
    My simple solution to all of this? I want to get above the £210k mark as fast as possible, this way it becomes irrelevant as I can only put 10k a year in and I dont need to think 🙂

    Cheers,
    FiL

    Like

    1. I’m with you on the mortgage overpayments. If only there was something I could do about the SAYE dividends (that is, without making myself poorer in absolute terms for the sake of paying less tax). Sadly, there isn’t.
      I like your solution.

      Like

  3. I think the hurried, badly written legislation, which has turned an already complex area into a multi-layered clusterfuck of convoluted rules, guidelines and definitions, really was the best he could do. George Osborne simply wasn’t a good Chancellor.

    Surely it has been forever thus, irrespective of chancellor?

    But it does sound super complicated – nice problem to have though as it means you’re earning mega-bucks. Although I imagine if you’re a Londoner it probably doesn’t feel that way?

    If it were up to me I’d simplify things by doing away with any taper, just let everyone have 40k regardless of salary. The 1m cap is too low as well, 2m sounds more sensible to me – don’t really understand why its plummeted down over recent years?

    I’d also go for a flat 30% tax relief on pensions (I’d prob extend this to a flat 30% rate of income tax but maybe thats too extreme?) All in the name of making things simpler.

    Its a strange state of affairs that ISAs have become absurdly generous and pensions absurdly tight of late. Maybe as you say its all a ploy to bring tax revenues forward in time?

    Like

    1. I kinda sorta like Hammond. At least so far he’s managed to restrain himself from introducing any wild, enthusiastic changes. I read McDonnell’s FT interview the other day. Christ. At first I was afraid, now I am petrified.
      And megabucks? Moi? ROFL. I’m so poor I can’t afford to pay attention, or throw my tuppence in the conversation, I have to make jokes about people at their expense. When I was young, we lived – all hundred and fifty of us – in a shoebox in the middle of the road.

      Like

  4. Hi 365,

    As a teacher I am nowhere near the 40% tax bracket, but I would love to have your problem!

    I see the LISA as the best of both worlds really sitting between the ISA and the SIPP. The 25% bonus is effectively our 20% tax returned back to us. I know it’s locked down until we are 60 and yes we would like to retire before this but we are filling our annual LISA limits as the product has tax free contributions now and tax free withdrawals down the line. Of course this could all be removed at the stroke of a politicians pen but we can only work with the information we have.

    Put one of us into the 40% tax bracket and this would all change but if you are a basic rate tax payer the LISA seems to be a better tax wrapper for now and the future. Once we hit 50 contributions to the LISA will be of no benefit as the 25% bonus is withdrawn, so we will go all in into our SIPPS and ISA accounts.

    The LISA seems to be getting a lot of bad press, but for people in our situation (basic rate payers) it seems a great product.

    QT

    Like

    1. I’m guessing as a teacher you’re also looking to receive a DB pension 😉 I don’t know if teachers’ pensions are underwritten by the government or not, but even if they are not, a guaranteed income floor in retirement is a nice thing to have, and an important consideration in retirement planning.

      Like

      1. Hi,

        I am not in the teachers pension scheme. It may raise a few eyebrows but I don’t appreciate the fact that upon death my spouse gets 1/3 of the pension and my kids won’t see a penny of it. With sipps and isas and clever tax management no wealth will die with me. I would love the tps to offer a DC scheme. I am also untrusting of the index linking of the benefits. 1/57th of salary growing at RPI every year? Over 40 years that’s bound to be eroded.

        Thoughts? 🙂

        Like

  5. The pension allowance taper really is horrible to understand and plan for.

    Someone can be below the threshold and adjusted levels all year, happily making pension contributions every month thinking they’ll be fine to contribute the full pension amount, then be generously rewarded in Jan with a pay rise or bonus that tips them over the limits. By that time it’s too late since the pension contributions have already been made.

    I’m sure I read you pay 50% tax on contributions over the limit, but can’t find that information now. If you do pay tax, how is the money collected? Out of PAYE/tax return or out of the pension itself?

    If there’s concern over putting a strain on state pension, why discourage people to invest in their personal pension?

    Like

    1. I agree. I’m planning to stop making monthly pension contributions from next year. I’ll wait until the end of the tax year when I have a better idea of what my annual allowance is going to be.

      Like

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