The Tax Implications of the Pension Annual Allowance Increase in the UK?

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As part of his “back to work budget“, on the 15th of March 2023, chancellor Jeremy Hunt announced that the pensions annual allowance would be increased from the beginning of the new tax year on the 6th of April. The aim is to encourage people to remain longer in the workplace.

What the Pensions Annual Allowance Does?

The pensions annual allowance dictates the limit regarding how much you can invest in your pensions every tax year while still allowing you to benefit from tax relief. It covers any contributions you, your employer, and anyone else might make. 

In the spring budget announcement, Mr Hunt confirmed that the current pension annual allowance of £40,000 per tax year will be raised by £20,000 to £60,000, with effect from the 6th of April 2023. 

Tax Implications of the Increase

There are tax implication for people that use the pension annual allowance to invest for their retirement. If you were to breach the annual allowance, you will be faced with a charge calculated in order to remove any upfront tax relief that your contribution would have merited. What that means is that if you are a basic rate taxpayer, that charge will be based on 20%, 40% if you’re a higher rate taxpayer, and 45% if you’re an additional rate payer.

How to Calculate Your Annual Allowance?

All contributions that you and your employer make to your pension pots are measured against your annual allowance. But don’t forget to take tax relief into account. Tax relief at the 20% rate in effect increases each contribution by 25%. To check if you’ve incurred a tax liability, you can use the calculator.

If you’re someone with a defined benefit pension, the calculation is rather more complex given that there isn’t a defined size of pension pot. The best way to establish where you stand is to ask your pension provider or a financial advisor.

Pensions Annual Allowance (and MPAA) Timeline

The pensions annual allowance was first introduced in 2006. The table below shows how it has changed over the years.

The money purchase annual allowance (MPAA) came into being in 2015. It is usually triggered when taking income from a flexi-access drawdown pension or by withdrawing a lump sum from a pension lump sum which is uncrystallised. Other actions can trigger it too.

The Tapered Allowance – How it Affects High Earners?

The tapered annual allowance for high earners came into effect on the 6th of April 2016. It limits the amount of tax relief you can claim on your pension contributions by reducing your annual allowance.

Up until now, if you had an adjusted income of over £240,000 per annum and a threshold income above £200,000, your pensions annual allowance was being squeezed. You lost £1 for every £2 you earned over £240,000, down to a minimum of £4,000.

The changes announced in the spring budget see the old tapering allowance change from £40,000 sliding down to £4,000, to £60,000 sliding down to £10,000.

In addition, the adjusted income threshold, which triggers the tapered allowance mechanism, has also been increased, in this instance, by £20,000, from £240,000 to £260,000, from the beginning of the 2023-24 tax year. 

How the Various Increases Benefit Investing for Retirement?

The increase to the annual allowance (AA) benefits the majority of people investing for retirement as it gives them the opportunity to invest more. The existing carry-forward rules allowing you to carry forward any unused annual allowances from the past three years can also be hugely beneficial if they are taken advantage of.

The changes to the MPAA are to be welcomed, albeit they are long overdue. Brought in originally to prevent wealthier individuals from milking tax freedoms by withdrawing large sums of cash to their advantage then recycling it back into their pension pots and benefiting from tax relief – the increase to the MPAA threshold prevents the ordinary saver from the risk of being caught out by a system that was aimed at wealthier system abusers.

The increases to the tapered allowance (TA), together with the abolishment of the lifetime allowance, are the final pieces that slip into place. All in all, if you are investing for retirement, these changes are long overdue and significant. They open the way for boosting everyone’s retirement savings.

Minimising your Tax Liability and Maximising your Retirement Savings

To make sure you minimise any tax liability when saving or investing for your retirement, simply make sure that you stay beneath all of the thresholds (AA, MPAA, TA) but maximise your pension contributions by getting as close to the thresholds as you can. Also, don’t forget you have the option to carry forward for any unused balances of your annual allowances from the past three years.

In terms of maximising your retirement savings, don’t forget you can make use of tax wrappers like investment ISAs. While you will have to be disciplined and avoid taking money out unnecessarily, stocks and shares ISAs not only provide you with CGT-free growth, but they also provide you with tax-free income.

What Might We See in the Future?

Although the Conservative chancellor has abolished the LTA, if the Labour party win the next election, which is widely expected, they have promised to reinstate the existing limit of £1.073 million. 

There is one school of thought that given the financial pressure that the government is under (and this won’t magically disappear under a Labour government) that future budgets might reduce pension contribution tax relief and even some of the pension freedoms, such as the 25% tax-free lump sum. 

But as we now seem to be on the right road with pension progress, following the introduction of workplace pensions, auto-enrolment, and the positive changes Mr Hunt has announced in his spring budget, any future negative changes could slow the trend down. 

However, it could be the case that a Labour government will look to penalise the wealthy and the higher paid, especially in the light of the comments made by shadow chancellor Rachel Reeves who said that the abolishment of the LTA was a “Tory tax cut for the rich,” and she labelled the changes as being  “the wrong priority, at the wrong time, for the wrong people.”