Although individuals can now get tax relief on pension contributions of up to 100% of their earnings in any tax year, if they exceed their annual allowance they will be liable to 40% tax.
As a result, high earners are effectively capped by this allowance – £215,000 gross in 2006/07, rising by £10,000 per year to £255,000 gross in 2010/11. Future increases will be at the discretion of the Treasury.
This all looks quite straightforward, but closer scrutiny reveals that it is possible to double up on the annual allowance with careful planning. This is because the annual allowance test is undertaken with reference to ‘pension input periods’ (PIPs) ending at any point in the tax year. By contrast, tax relief is granted by reference to earnings and the contributions an individual actually pays in the tax year.
How it works
To find out whether the annual allowance has been exceeded in a tax year, contributions to money purchase schemes and the deemed value of defined benefit accrual are combined to calculate an individual’s ‘pension input amount’ for all PIPs ending in that tax year. If the total pension input amount for PIPs ending in the tax year exceeds the annual allowance, the 40% annual allowance charge applies.
Strictly, the PIP for a new plan commences when the first contribution is made after 5 April 2006 and ends on the anniversary of that date, unless the member notifies the scheme administrator of an earlier end date. If, for example, the first contribution after 5 April 2006 is made on 1 December 2006, the first PIP will end on 30 November 2007. As this falls in the 2007/08 tax year, the pension input amount will be tested against an annual allowance of £225,000 gross, not £215,000 gross. Whilst this gives an additional £10,000 capacity compared to a PIP ending in 2006/07, it also means that the 2006/07 allowance is unused. This could be problematic if the individual is close to retirement and wishes to maximise his/her contributions.
Planning opportunities
The ability to nominate the first PIP end date presents an opportunity for high earners to double their contributions in one tax year, providing they have sufficient earnings.
This is achieved by contributing £215,000 gross into a new plan and nominating the PIP end date as, say, 31 December 2006. As this is in the 2006/07 tax year, the contribution is tested against the annual allowance of £215,000 gross.
A further contribution of £225,000 gross can then be made to the same scheme between 1 January 2007 and 5 April 2007. This PIP will end on 31 December 2007 and the contribution will be tested against the 2007/08 annual allowance of £225,000 gross.
As tax relief is granted with reference to the tax year of payment, not the PIP, the individual will receive relief on contributions of £440,000 gross in 2006/07, providing they have sufficient earnings in the tax year. 22% basic rate relief will be given at source whilst an additional 18% higher rate relief of £79,200 will be due from HM Revenue & Customs (HMRC).
There will be no annual allowance charge as the individual will not have exceeded the annual allowance for either 2006/07 or 2007/08.
It is vital, however, to ensure that any contributions paid into the same plan in the 2007/08 tax year are delayed until after 31 December 2007, and the PIP for 2008/09 has begun.
In an extreme example it would be possible to pay pension contributions of £675,000 gross over four days commencing on 3 April 2007, and obtain full tax relief without triggering any clawback, but this requires very careful planning.
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