In order to avoid a pensions shortfall in later life, we’re often advised to pay as much as we can afford into our pension pots. And the sooner we start, the better – or so the thinking goes. But is there such a thing as “too much” when it comes to pension contributions; and what impact can this have on the tax we pay?
You can contribute up to 100% of your earnings to your pension each year or up to the Annual Allowance of £40,000 (2020/21). This means the total sum of any personal contributions, employer contributions and government tax relief, can’t exceed the £40,000 pension Annual Allowance.
Contributions that exceed the £40,000 Allowance are subject to a tax charge in line with income tax. Under the right circumstances you may have the option to carry forward any unused allowances from the previous three years, totalling up to £120,000, on top of your current year’s Annual Allowance.
If you’re working full time and are nearing retirement it can be advisable to save as much as possible. Just don’t forget to double check how much of your Allowance you’ve used in recent years and any contribution is within the agreed limits.
For those who have already begun drawing a pension, however, the Annual Allowance for contributions under the Money Purchase Annual Allowance (MPAA) is capped at only £4,000.
Very high earners may be subject to the Tapered Annual Allowance (TAA), which came into effect from 6 April 2016. From 2020/21 onwards, for every £2 of ‘adjusted income’ above £240,000, £1 of allowance is lost. This only applies, however, where the individual’s ‘threshold income’ exceeds £200,000. A technical discussion of the terms ‘adjusted income’ and ‘threshold income’ is beyond the scope of this article. The maximum reduction is £36,000, meaning the Tapered Annual Allowance for the individual could be as low as £4,000.
In addition to the Annual Allowance, a Lifetime Allowance is also applicable and places a limit on the value of pension benefits you can receive in a lifetime without having to pay excess tax. For 2020/21, the Lifetime Allowance is capped at £1,073,100.
If you exceed the Lifetime Allowance, you’ll be subject to an immediate tax charge whenever you take the excess benefits from your pension. 25% will be charged if paid as a pension or 55% if paid as a lump sum, plus income tax at your standard rate.
Drawing your pension
Once you reach age 55 or over, you are eligible to start drawing your pension. You can take up to 25% as a tax-free lump sum and will be charged income tax at your highest rate thereafter.
As always with investments, your capital is at risk. The value of your investment can go down as well as up, and you may get back less than you invest. The above information should not be regarded as financial advice.