Pensions are a critical component of a retirement plan. The pension system in the UK is ranked highly throughout the world, not only for the retirement benefits, but also for the tax relief received on payments made towards pension accounts.
All individuals living and working in the UK with a UK National Insurance Number, are eligible for a pension. There is no upper limit on the amount that you can save in your pension each year; however, government have put a cap on the tax benefits that the pensioners can receive. Therefore, it is necessary for taxpayers to understand the various rules and regulations regarding a pension in the country they live, allowing them to manage their pension allowance effectively for optimum tax relief and higher savings for retirement.
Annual Allowance
The annual allowance is the upper limit or the cap, defined by the government on the amount that individuals can get tax relief, on the money they have saved in their pension accounts. The annual allowance is made up of all the contributions that the individuals, their employees, and any third parties make towards the pension account.
For the tax year 2020-2021, the annual allowance is at £40,000 or 100% of your income, whichever is lower. It means that you can save any amount in your pension account, but you will receive tax relief only on the maximum of £40,000 annual allowance. It implies that someone at the standard tax rate of 20%, can only receive a maximum pension tax relief of £8,000 towards their pension pot.
Furthermore, if you exceed your annual allowance, you will not receive any tax relief on that additional contribution over and above the annual allowance and will also attract an annual allowance charge. The additional charge is added to the overall taxable income for the year and paid out of the pension scheme funds.
Lifetime Allowance
The Lifetime Allowance is another factor to be considered by pensioners in the UK. It is an upper limit on the total amount of pension benefits that you can draw from the pension schemes, either in the form of a lump-sum amounts or retirement income. It applies to all pension arrangements, including defined benefit schemes and personal pension schemes, but excludes state pension schemes.
Lifetime allowance for the year 2020-2021 is at £1,073,100. It may appear to be a hard-to-reach amount, but even modest pension contributions over a long period may lead to your pension benefits approaching lifetime allowance. If your pension contributions are close to reaching lifetime allowance, you may take your pension early or stop making further contributions to the pension plan to avoid paying an additional tax charge.
Money Purchase Annual Allowance
Those who have taken a lump sum payment from their pension account in the form of an uncrystallised funds pension lump sum (UFPLS) or take income through Flexi-access income drawdown or flexible annuity, can still pay towards a pension scheme and earn tax relief.
This yearly allowance is lower than the annual allowance and is termed as money purchase annual allowance (MPAA). Money purchase annual allowance is capped at £4,000 or 100% of your income, whichever is lower, for the tax year 2020-2021.
Tapered Pensions Annual Allowance
To establish income parity to a large extent, the annual allowance limit keeps going down as income keeps going up. It means that with increases in the adjusted income, annual allowance decreases from £40,000, proportionally. This is called a tapered pensions annual allowance(TPAA).
According to the amendments made by the Chancellor in April 2020, the threshold income increased to £200,000 and the adjusted income went up to £240,000. The individuals at an adjusted income of £240,000 have a cap of £40,000 on their annual allowance, and thereafter for every £2 increment in the adjusted income, annual allowance reduces by £1. Following the same progression, annual allowance for someone with adjusted income of £300,000 drops down to £10,000 and further to £4,000 for anyone earning more than £312,000.
Carry Forward Allowance
If you have been unable to use up your annual allowance from previous years, you can carry forward your annual pension allowance for the previous three tax years. However, you must be able to earn the amount that you want to contribute in the current year and must have been a member of a registered pension scheme in those tax years. The contributions from employers and third parties also count towards the carry forward allowance.
Bottom Line
As a bottom line, with the various rules and regulations it is critical for pensioners in the UK to understand pension allowances to maximise their tax relief and retirement savings. Individuals can also seek professional advice to ensure that they are making optimum use of their allowances and taking maximum tax relief from their pension contributions.