Pensions are for many the first and best savings vehicle. The tax incentives – tax relief at your highest income tax rate on what you pay in – are generous. You get tax-free growth on assets held inside the pension, and there are inheritance tax advantages too.

But for many these benefits are limited.

That’s because the tax perks are clawed back for higher earners, which can present difficult calculations as to how much can be saved. Worse, a risk of penalties applies to those who accidentally contribute too much.

The pension contribution basics…

Most people can pay up to 100% of their earnings into a pension up to £40,000 per tax year.

…and now the pension problem for higher earners

If you earn above a certain point, your annual £40,000 pension allowance starts to reduce, or “taper”. The taper starts to take effect where your “adjusted income” [see below for more on this] exceeds £240,000 per tax year, as of 2021-22. From there, your £40,000 is tapered down based on how much your income exceeds the limit.

The maximum reduction in the allowance is £36,000: this means you have an annual allowance of just £4,000.

To reach this scenario you will need to have an adjusted income of £312,000 or more.

The complex bit: your “threshold income” and “adjusted income”

First master the terminology. Your “threshold income” is all your income (salary, bonus, dividends and other investment income) but not including your pension contributions.

Your “adjusted income” is the above plus your employer’s pension contributions.

Under current rules the taper will apply if TWO conditions are met:
1. Your threshold income is above £200,000
2. Your adjusted income is above £240,000

Why were these bewildering rules introduced? Chris Hogarth, Wealth Planning Director at Cazenove Capital, explains: “One possible answer is that the Government wanted to prevent higher earners from dodging the taper by simply swapping some of their wages for bigger pension contributions. Also, the rules are supposed to allow lower earners to experience occasionally high contributions to their pensions without triggering the taper reduction.”

Watch how the pension taper works in practice

Let’s assume the current rules apply in relation to maximum threshold and adjusted incomes.

Tax year 1:

Angela has a basic salary of £120,000, a bonus of £40,000, and income from her rental property and other investments of £35,000.

Her company contributes £40,000 to her pension.

Outcome: Angela escapes the taper because her threshold income is £195,000 and therefore below the £200,000 limit. Her full £40,000 allowance is intact.

Tax year 2:

Angela’s wage has risen to £140,000, her bonus is £55,000 and her rental and other income remain at £35,000.

Because Angela’s threshold income (£230,000) is now above the £200,000 limit, she needs to calculate her adjusted income. The £40,000 employer pension contribution would push her adjusted income to £270,000.

Outcome: The taper does now apply, reducing her annual allowance by £1 for every £2 that her adjusted income exceeds the £240,000 threshold. In this case the excess is £30,000, and so the reduction in her allowance is £15,000. For this year she may contribute just £25,000 into a pension.

Does that mean pensions are a total no-go for high earners?

No, says Chris Hogarth. “It is the case that if your earnings regularly exceed £312,000 your annual allowance of £4,000 (the lowest) will drastically curtail the utility of pensions.

“But in reality many people’s total income is variable and the pension system – byzantine as it is – does make some allowance for that.”

One key loophole of use to many is “carry forward” – an ability to claim un-used annual pension allowances from previous tax years. But working out exactly what these entitlements might be is a headache. That’s because earlier years may have had different taper rules and these need to be applied to work out what you’re entitled to.

Give the headache to a planner

If your situation puts you in or near the scenarios above, you would probably save money by paying for the help of a professional planner.

The many variables – changes in your pay, bonus, pension contributions and other income – make for horrible calculations even without taking into account potential changes to tax thresholds and rules.

The financial benefit of maximising pension tax relief and avoiding penalties could far outweigh fees paid.

Statements concerning taxation are based on our understanding of the taxation law in force at the time of publication. The levels and bases of, and reliefs from, taxation may change. You should obtain professional advice on taxation where appropriate before proceeding with any investment.

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