Stephen McPhillips: Tapering and annual allowance complexities

Stephen McPhillips takes a look at the annual allowance, tapering and all the complexities therewith. As is often the case with pensions, the devil is in the detail, and it pays to be precise with calculations, he writes

The annual allowance (AA) has been with us since its introduction way back on pensions “A-Day” in 2006.

As part of a wider package of measures to tackle “pensions simplification” the AA swept away some of the complexity around maximum funding calculations for occupational pension schemes (such as small self-administered schemes (SSAS)) whereby tax relievable pension contributions had to be determined by reference to the pensionable earnings and length of prospective service for each scheme member individually.

Simplification?

In that respect, an element of simplification was achieved. However, changes to the AA over the years, combined with the need to align the AA with pension input periods (PIPs) have made the AA more complex than it first appeared would be the case.

Thankfully, all PIPs now end uniformly on 5 April each year, but there’s still complexity around the AA and it has to be considered carefully.

Tapering complexity

One of the challenges around the AA relates to the relatively new concept of “tapering.” This was brought into existence on 6 April 2016 and, where it bites, it reduces the scheme member’s AA on a sliding scale where his or her “adjusted income” and “threshold income” exceed the relevant limits.

These income figures are defined, and they capture a lot of forms of income, so careful attention has to be paid to the member’s overall source of wealth in a given tax year. For example, “adjusted income” includes the member’s earnings, dividends, interest on savings and pension contributions (including those made as a result of a salary sacrifice (or similar) arrangement.

Recent events

Readers will probably be familiar with the fact that from 6 April 2020, “adjusted income” and “threshold income” amounts were increased by £90,000 each, thereby taking large numbers of pension scheme members out of the scope of tapering (most notably some senior clinicians in the public sector). Hence for the tax year 2020/21, “threshold income” was set at £200,000 and “adjusted income” was set at £240,000 and that is the case for the tax year 2021/22.

However, the maximum effect of the taper from the 2020/21 tax year onwards has also changed. Prior to this, tapering could only reduce the AA to £10,000. Now, the AA can be reduced to as little as £4,000, and this amount would apply where the member’s adjusted income in the tax year is £312,000 or more. 

Further considerations – carry forward

So, it’s already quite a complex landscape when it comes to determining a scheme member’s AA. When we then start to think about the possibility of “carry forward” of unused AA, things don’t get any easier. That’s because tapering may have been applicable for the member in any of the tax years available for the carry forward exercise.

Looking at the 2021/22 tax year from a carry forward perspective, it is possible to carry forward unused AA from the completed tax years 2018/19, 2019/20 and 2020/21; all of these completed tax years may be affected by tapering, depending on the member’s earnings.

Indeed, even a stable pattern of earnings over the past three completed tax years could actually give rise to quite different amounts of AA being available for carry forward.

Let’s take, for example, a member whose adjusted income was £200,000 in the 2019/20 tax year. The effect of the tapering would be to bring the available AA down to £15,000 in that tax year. That’s because that member’s adjusted income exceeded the limit of £150,000 which was applicable then, and the AA was tapered down accordingly.

However, if we then look at the tax year 2020/21 where the member’s adjusted income was once again £200,000, we deduce that the member has a full £40,000 AA available. That’s because of the £90,000 increase in the adjusted income definition for that year; it has effectively taken the member out of the scope of tapering in that year, despite the fact that earnings were the same as the previous year where tapering had applied.

As is often the case with pensions, the devil is in the detail, and it pays to be precise with calculations!

Stephen McPhillips is technical sales director at Dentons Pension Management