EXPLAINING HOW ANNUAL ALLOWANCE AND EARNINGS LIMITS INTERACT- Source – Old Mutual Wealth

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

Examples

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.

ISAs 20 years on

ISAs – 20 years on

S pensionpigource and Credits – Standard Life Technical

This is the year ISAs turned 20 and statistics suggest it has become a huge hit with savers. The value of adult ISAs stand at over £600 billion, shared between around 22 million account holders.

They have also proved popular with successive Chancellors as a means of encouraging the saving habit with the annual subscription limit having almost trebled since launch.

Their relative simplicity has undoubtedly played a key part in this success, but they’re more than just a tax free piggy bank.

ISAs have evolved over the last 20 years to play an important role in shaping and influencing how clients organise their wealth to achieve their life goals.

Instant Access

One of the main attractions of an ISA is that savings can be accessed at any time, whether invested in cash or stocks and shares. This removes any emotional barrier to not being able to access your own money when you want to and that makes them ideal for building up a ‘rainy day’ fund, or targeting for a specific event at a future date.

The introduction of schemes such as Help to Buy and Lifetime ISA (LISA) have added a little more complexity but with some added incentives for first time house buyers provided they meet certain conditions. The LISA also provides the same incentives for retirement provided clients don’t access the money before age 60.

More recent innovations include:

  • ‘Flexible’ ISAs – ISAs where the provider will allow funds to be withdrawn and replaced within the same tax year without affecting the annual subscription limit. This can be particularly useful for those who need money in an emergency. But before withdrawing funds always check that the ISA manager offers this flexibility. Not all providers offer it and once withdrawn it cannot be repaid to a different ISA.
  • Additional permitted subscriptions (APS) – widowed clients can now claim a one-off subscription limit equal to the value of their deceased partners ISA at date of death. This can be significant in protecting assets from income and gains. ISA savers in the 65 and over group account for the highest average savings value of over £42k, and it’s not uncommon to hear of accounts in excess of £100k. For deaths after 5 April 2018 the value will not only cover the value at date of death, but in most cases the income and capital gains made during the administration period of the estate.

Tax benefits

The ‘tax free’ status of ISA investments is the main draw. There’s no tax on income or gains during roll-up or at the point of withdrawal. This can boost savings, but will also reduce tax administration as self-assessment is not required.

The tax free treatment of income and gains can free up allowances and lower rate tax bands for other assets outside the ISA, such as buy to lets, dividends from owner managed businesses and other investments.

In addition, the income generated from ISAs doesn’t count towards any of the income definitions that determine the personal allowance, pensions tapered annual allowance or child benefit tax charge.

ISAs may also help clients who wish to take gains out of a portfolio within their annual capital gains tax allowance. If they want to buy back the same shares or OEICs, they would normally have to wait 30 days because of the ‘share matching rules’. But such shares can be bought back through an ISA immediately, so that clients are not out of the market for a month. This transaction is sometimes referred to as ‘bed and ISA’.

IHT and retirement planning

ISAs can dovetail neatly with other forms of tax and retirement planning to create a better outcome for clients.

As a client gets older and their need for an ’emergency’ fund diminishes, they may be looking to retirement needs and leaving a tax efficient legacy for their family.

If they’re close to, or at retirement it may make sense to consider maximising pension funding from their ISA savings if they don’t have other resources. There are several reasons for this:

  • Pensions offer the most attractive tax incentives for most people. Tax relief at highest marginal rates on the way in, and the availability of 25% tax free cash on the way out will prove a better deal than ISA for most people seeking a retirement income, even if they pay the same rate of tax in retirement as when they were working.
  • Pensions can be accessed at any time after age 55.
  • Pensions are protected from inheritance tax. ISAs will normally form part of the holder’s taxable estate and potentially liable to IHT at 40%. There could, of course, be a tax charge on pensions when a beneficiary draws money from an inherited pension pot, but only if the member died after the age of 75. Even then the tax charge will be at the beneficiary’s own tax rate which may be less than 40% and delayed until it is actually taken. But there may be an opportunity to manage affairs to ensure it’s taken in a year when other income is low.

The pension option will, of course, depend on clients having enough pensionable earnings and annual allowance, and an eye must also be kept on where funds stand in relation to the pension lifetime allowance.

Funding a pension using ISA funds won’t always be possible, either because a client has no pensionable earnings or has perhaps triggered the £4k money purchase annual allowance. But ISA funds may still have a part to play in effective retirement planning. Retirement income needs could be better served from the ISA rather than pension, again for IHT reasons – better to use a pot that is subject to IHT than one that isn’t.

Clients can, however, engage in IHT planning with their ISA even if they don’t wish to, or are not able to recycle into pensions:

  • Any income produced in the ISA and taken by the client can be included in valuing income in relation to the ‘normal expenditure out of income’ exemption. If this income adds to, or creates ‘surplus’ income, it can be given away and will be immediately outside the client’s estate.
  • Those able to take on greater risk could turn to an ISA that facilitates investment in shares on the alternative share market (AIM shares). Once held for two years, and provided the shares remain qualifying, they won’t get caught in the IHT net.

Investment planning

A client’s plans on how they intend to use their ISA savings will of course influence how it’s invested. If ready cash is needed, or funds are earmarked for a specific date (particularly if that date is short term), they’re not likely to take on much risk. Funds may therefore sit in deposit or fixed interest funds.

But if a client has both ISA savings and non-ISA savings, given the historically low interest rates and the availability of the personal savings allowance (PSA), it may be advantageous to keep their ISA invested predominantly in stocks and shares with their ready cash held outside their ISA. This is because stocks and shares are more likely to provide a higher return than interest, and so the ISA wrapper will give greater protection from tax, particularly if there would be no tax on interest anyway. And stocks and shares can now easily be moved into cash within an ISA if a client’s attitude to risk changes.

Similarly, if a client wishes to use their ISA to hold stocks and shares but there are bear market conditions at the time they wish to make their subscription, they could always make pay into a cash ISA. This means their subscription is not wasted, and will be ready to move into stocks and shares when market conditions are more favourable.

And of course, why wait until the tax year end to take advantage of the annual subscription. Probably down to human nature, but many will leave it until the tax year end before paying in and will have missed out on nearly a whole year of tax free income and growth.

Summary

ISAs have evolved over the last 20 years into a flexible savings plan that’s central to the holistic financial planning for a client. Much more than just a rainy day savings plan.

Source and Credits – Standard Life Technical -30 April 2019

As Independent Financial Advisers we can help and advise you on the tips listed above. Just give us a call on 0345 013 6525 to discuss.