The Hidden Tax Trap: How High Earners Can Lose Out on Pension Savings
Imagine earning a substantial six-figure income but being unable to maximize your pension contributions due to a little-known tax trap. This is the reality for Zoe Mansell, a business consultant from Reading, who has hit the £260,000 income threshold, limiting her pension payments.
In the UK, most workers can contribute up to £60,000 or 100% of their salary (whichever is lower) to their pension each year while enjoying tax relief. However, Zoe's situation is more complex. When your 'adjusted' income (including wages, property income, investment income, and employer pension payments) surpasses £260,000, and your 'threshold income' (total income minus pension contributions and eligible deductions) exceeds £200,000, the £60,000 allowance starts to decrease by £1 for every £2 earned above £260,000. This reduction continues until it reaches a minimum of £10,000 at an income of £360,000.
But here's where it gets controversial: If you contribute more than £10,000 to your pension in a year, HM Revenue & Customs may treat it as an unauthorized payment, resulting in a hefty tax bill of 40-55%. This can effectively eliminate any tax relief benefits.
Zoe Mansell, 45, has chosen to stop contributing to her pension. Last year, her income exceeded £400,000, including £340,000 in pay and additional income from property and savings. Had she and her employer made the 8% minimum pension contributions under auto-enrolment, it would have totaled £17,600. If taxed at 55%, she could have lost over £4,000 on the excess above the allowance.
"I negotiated with my employer to receive employer contributions only up to the £10,000 limit," Mansell explained. "The company offered 10% matched contributions, but that would trigger the annual charge."
A Catch-22 Situation:
In the 2023-24 tax year, around 50,000 people faced tax charges for exceeding their annual pension allowance, according to HMRC. Others may have avoided this by utilizing allowances carried forward from previous years, a strategy known as 'backfilling.'
Mansell acknowledges the fairness of the system but suggests improvements: "I understand that higher earners should contribute more. However, extending the backfilling period when caught in these unique tax traps would be beneficial. Additionally, the rules should allow for the auto-enrolment minimum pension payment, even if it exceeds the tapered allowance."
The tapering of the annual allowance was introduced in 2016, starting at an adjusted income of £150,000. It faced criticism for causing issues for public sector workers, particularly senior doctors in final salary pension schemes. The complex valuation of employer pension contributions can lead to doctors inadvertently exceeding their pension allowance.
The Ever-Changing Tax Landscape:
The adjusted income threshold was raised to £240,000 in 2020 and further increased to £260,000 in 2023. However, it has remained unchanged despite rising earnings in various sectors. This fiscal drag will likely ensnare more earners, causing them to lose a portion of their pension saving allowance each year.
Jon Greer, head of retirement at Quilter, emphasizes the importance of awareness: "The tapered annual allowance is a pension rule that catches many people off guard."
Navigating the Tax Maze:
Greer advises those nearing the thresholds to understand their income calculations for the annual allowance to avoid the 55% tax charge. Strategic planning, such as timing bonuses, reviewing pension contribution methods, and utilizing unused allowances from previous years, can help minimize tax bills.
Mansell's experience highlights the challenges of self-employment and changing employment statuses. She suggests being mindful of salary sacrifice, directors' pension allowances, and tax treatments for effective long-term planning.
Kirsten Pettigrew from Rathbones offers a strategic perspective: "The tapering allowance prevents high earners from accumulating large pension sums. They must plan for retirement strategically, considering other allowances like Isas, general investment accounts, or offshore bonds. Utilizing household pension allowances, such as a spouse's allowance, can also be advantageous."
The Importance of Tax Diversification:
Pettigrew emphasizes the value of exploring different tax wrappers, as tax legislation can change by retirement. The carry-forward rules provide high earners with time to catch up on unused pension allowances.
Another Trap to Avoid:
Additionally, higher earners should be cautious of another tax trap. Once your adjusted net income surpasses £100,000, you begin to lose your personal allowance of £12,570, which is the income you can earn tax-free. For every £2 earned above the threshold, you lose £1 of this allowance, resulting in a marginal tax rate of 62%, including national insurance.
This trap can also affect young families, who may lose access to government-funded childcare and tax-free childcare benefits. Despite these income levels, many individuals do not consider themselves wealthy, highlighting the complexities of the UK's tax system.
