When looking to make a contribution into a pension an individual must consider annual allowance & carry forward, and tax relief limitations relating to earnings.
The annual allowance may limit contributions made each tax year but carry forward can be used to contribute more. Both employer and personal contributions count towards the annual allowance.
Personal contributions can be limited by relevant UK earnings but employer contributions are not.
Employers may be able to reduce their tax bill by making a pension contribution but need to be careful they don’t put in too much, otherwise they will cause a tax charge for their employee.
It is important to understand that the annual allowance, personal contributions and employer contributions all have separate rules but also impact on each other. Understanding these rules will allow you to maximise contributions and avoid finding out later a tax charge applies.
The annual allowance can limit contributions made in the tax year
The standard annual allowance this year is £40,000. The individual’s annual allowance may be lower if they are a high earner or have triggered the money purchase annual allowance.
All contributions, no matter who pays them, count toward the annual allowance limit.
If contributions are made above the annual allowance, this may lead to a tax charge.
Carry forward can be added to the annual allowance
Unused annual allowance from the three previous tax years can be added (carried forward) to the current tax year’s annual allowance.
An individual can only carry forward from a year they were a member of a registered pension scheme for at least part of that year.
If they have triggered the money purchase annual allowance, carry forward is not available for contributions into money purchase schemes,
Tax relief on personal contributions are limited by relevant UK earnings
Individuals are entitled to tax relief at marginal rate on £3600 or up to 100% of relevant UK earnings for this tax year. For most people, this will be their salary. Income from dividends and rental income are not classed as relevant UK earnings.
Most personal pension schemes operate relief at source. This means basic tax relief is added by the pension scheme whilst additional tax relief is claimed via self-assessment. Because tax relief is limited and these schemes give tax relief up front, they will likely only accept contributions up to the individual’s relevant UK earnings.
It is possible to make a gross personal pension contribution above a person’s relevant UK earnings but it may be hard to find a provider willing to accept this.
All personal contributions made will count towards an individual’s annual allowance and carry forward.
Many people confuse unused annual allowance and unused earnings when looking at carry forward. It is only unused annual allowance that is carried forward. Unused earnings from previous years are not carried forward.
Employer contributions are not limited by relevant UK earnings
Employer contributions do not receive tax relief in the pension. As no tax relief is given, the employer contribution is not limited to the employee’s earnings like personal contributions.
However, if the employer pays in more than its employee’s annual allowance and carry forward, the employer will cause a tax charge for the employee. This is because all employer contributions will count towards annual allowance and carry forward.
An employer may be able to reduce the company’s tax bill by making a pension contribution but need to be careful they don’t put in too much
Many employers will want to offset the money they have paid as an employee pension contribution against their company tax bill. A pension contribution can be classed as a business expense. Whether this expense can reduce the company’s tax bill will depend on if the expense is wholly and exclusively for the purpose of the business. An accountant is the best person to assess the business expense.
Whilst an accountant might tell an employer they can justify a certain amount of pension contribution, the amount contributed might cause a tax charge. Remember annual allowance and carry forward include all types of contributions.
The annual allowance, personal contributions and employer contributions all have separate rules but also impact on each other
When deciding on the level of contribution to make an individual will need to consider how these rules and limits interact.
Whilst that individual may have available capital and annual allowance they may not have the earnings to make a personal contribution.
Alternatively whilst they have the earnings, they may not have available annual allowance and carry forward.
An employer may wish to make a pension contribution but not benefit by doing so if the expense is not justified.
It is important to look at how each contribution type is limited and then consider annual allowance and carry forward at the same time. If not, the individual may end up with a tax bill, the employer may not get the tax benefit they thought they would or the pension may have more tax relief within it than it should do.
A simple way to determine what contribution to make would be:
- Determine what the individuals annual allowance is
- Determine how much carry forward is available from the previous 3 tax years if applicable
- Add the carry forward figure to this years remaining annual allowance
- Determine how much has been paid for or will be paid for by all parties in this tax year
- Decide who will be paying the contribution
- If it is the employer, determine how much the employer can contribute without an annual allowance tax charge. The employer will determine if they can claim this as an expense
- If it is a personal contribution, look at this year’s relevant UK earnings.
- If the relevant UK earnings are higher than the remaining annual allowance and carry forward, the individual will know how much can be contributed
- Where a contribution receives tax relief, the maximum contribution will be equal to the relevant UK earnings if they are lower than the remaining annual allowance and carry forward
Below are some examples that should help bring the rules to life. The assumption for the below examples are that the standard annual allowance applies and the salary is the total relevant UK earnings.
Case 1) Mr A has a salary of £30,000. He is a deferred member of a registered pension scheme opened 10 years ago. He has not made any contributions for the last 5 years. How much can he put in the pension as a personal contribution with tax relief?
Mr A has this year’s annual allowance. He also has the previous 3 tax year’s annual allowance available as he was a member of a registered pension scheme in those years. This means the most that can go into the pension with no tax charge is £160,000 (£40,000 for this year and £40,000 carried forward from each of the previous 3 years).
Mr A only has a salary of £30,000 so regardless of the annual allowance available, he can only make a gross contribution of £30,000. If paying into a scheme that offers relief at source he will pay £24,000 and the pension scheme will add the rest.
This is because a personal contribution is limited to 100% of relevant UK earnings. Making a gross contribution of more than £30,000 will mean Mr A has received more tax relief than he is entitled to.
An employer could pay a contribution to make up the difference.
If Mr A puts more than his earnings into the pension the pension will contain more tax relief than is allowed. This will need to be rectified.
But what about the fact that Mr A earnt £30,000 each year for the last 3 tax years?
Carry forward does not enable unused salary from previous years to be carried forward to make a higher contribution than this year’s relevant UK earnings. You can never make a personal contribution with tax relief in the tax year that is larger than the relevant UK earnings for the tax year.
Case 2) Mr B has a salary of £80,000. He joined a registered pension scheme for the first time last year by paying in £30,000. How much can he put in the pension as a personal contribution with tax relief?
Mr B has this year’s annual allowance and can carry forward unused annual allowance from last year. As he was not a member before then, he cannot carry forward from other years.
This means the most that can go into the pension with no tax charge is £50,000 (£40,000 for this year and £10,000 carried forward from last year).
So in this scenario, even though Mr B has earnings of £80,000 he is limited to £50,000.
Case 3) Mr C has a salary of £70,000. He is a deferred member of a registered pension scheme opened 7 years ago. He has not made any contributions for the last 5 years. How much can his employer pay into his pension?
Mr A has this year’s annual allowance and the previous 3 tax year’s annual allowance available.
This means the most that can go into the pension with no tax charge is £160,000 ( £40,000 for this year and £120,000 carried forward).
Mr C’s earnings are irrelevant as he is not making a personal contribution. The employer can make a contribution of £160,000 gross.
Does that now mean the company can claim £160,000 as an expense that is offset against the company’s tax bill?
Just because a pension contribution won’t cause a tax charge for Mr C does not mean it can automatically be used to offset a company’s tax bill.
Just like any other expense like a company car or business lunch, it needs to be wholly and exclusively for the purpose of the business to be offset against the company’s tax bill. A company accountant will normally give guidance to an employer about how much it could claim as a business expense.
Annual Allowance and Carry forward
|Personal Contributions count
towards annual allowance
|Employer Contributions count
towards annual allowance
|Tax relief Limited to 100% of relevant
UK earnings in this tax year
|No limit on what is paid in pension
but may be a limit on how much can
be offset against company tax bill.
The information provided in this article is not intended to offer advice.
It is based on Old Mutual Wealth’s interpretation of the relevant law and is correct at the date shown on the title page. While we believe this interpretation to be correct, we cannot guarantee it. Old Mutual Wealth cannot accept any responsibility for any action taken or refrained from being taken as a result of the information contained in this article.