PENSIONS - 31.03.2011

Tax breaks for excess pension contributions?

Maximum pension contributions

It’s not widely realised that the maximum contributions you can pay into your pension fund and the maximum on which you can claim tax relief are two different figures. While tax relief is restricted to contributions of £50,000 per year, the amount you can pay into a fund can exceed this. For most people the £50,000 is sufficient, but others may want to invest larger sums, say those who have little in the way of pension savings or want to make use of the tax-free status of a pension fund. But what are the tax consequences of this?

Bad news - annual allowance charge

Where you, your company, or both of you together, contribute more than the £50,000 limit into your pension, you can claim tax relief on all of it. But you must also declare the excess over £50,000 on your self-assessment tax return (on which you’ll pay tax). This tax is called the annual allowance charge (AAC) and the effect of it is to claw back tax relief on pension contributions in excess of £50,000.

Tip. By changing the pension input period (PIP)for the pension scheme to soon after the end of the tax year, e.g. April 30, you can defer the AAC to the year following that in which you get your tax relief (see The next step).

Example.Tom doesn’t have a pension scheme until he sets one up in May 2011. The level of his income in 2011/12 means he’ll pay tax at 40%. He pays £60,000 into his pension and the Taxman tops this up with basic rate (20%) tax relief of £15,000 making a gross pension contribution of £75,000 (£75,000 x 20% = £15,000). Tom can claim higher rate tax relief, i.e. another 20%. As he pays tax under PAYE he asks the Taxman to amend his code number so that between May 2011 and April 2012 he’ll get the £15,000 higher rate tax relief through his salary. He’ll have to pay back £10,000 of this as an AAC because his contribution exceeds the £50,000 limit (see The next step). But this will be much later. The AAC arises in the tax year in which the PIP for Tom’s pension ends. For a new pension scheme, the PIP ends on the anniversary of when the policy commenced, i.e. May 2012. This falls in 2012/13 and under self-assessment the AAC is payable on January 31 2014. So Tom starts receiving the tax relief in May 2011 but doesn’t have to pay back the excess until two years later.

Tip. In fact, Tom can avoid paying a penny of the AAC out of his own pocket. Under new rules announced in March (see The next step), where an AAC exceeds £2,000 you can ask your pension company to pay the charge out of your fund. This would mean Tom can keep all of the tax relief and will only feel the effect of the AAC at the time he takes his pension.

Another tax perk

Where your pension fund value is £1,500,000 or less, it doesn’t have to pay tax on income and gains it generates. So although tax relief on contributions greater than £50,000 per year will be clawed back through the AAC, the extra investment will still benefit from the tax-free growth.

For more information on PIPs (TX 11.13.05A) for the calculation of the AAC (TX 11.13.05B) and for the new rules on AACs (TX 11.13.05C), visit http://tax.indicator.co.uk.