Understanding Pension Carry Forward Allowance

When it comes to retirement planning, staying abreast of changes to pension regulations is vital for securing your future and staying within the tax rules. One significant change that has taken place fairly recently is the adjustment of the pension carry forward allowance to £60,000 per year. This article aims to simplify this alteration and its implications, alongside explaining key terminology such as threshold income, adjusted net income. We will also look at a worked example as well as explaining the tax benefits of pension contributions.

The Evolution of the Carry Forward Allowance

The carry forward rule is a boon for individuals aiming to bolster their pension savings. Historically capped at £40,000 annually, the unused allowance can now be carried forward up to £60,000 from April 2023. This modification empowers individuals to compensate for previously missed contributions by utilising any untapped allowance from the current as well as the preceding three tax years.

Please be aware to take advantage of the carry forward allowance you must have been a member of a pension scheme in the previous tax years you are utilising your allowance from – typically most employed tax payers looking to do this are part of their employer scheme which can suffice.

This enhancement is particularly advantageous for those experiencing income fluctuations or seeking to optimize their pension strategy. By allowing retroactive contributions without incurring penalty charges, the new allowance facilitates strategic pension planning.

Deciphering Threshold Income and Adjusted Net Income

To leverage the carry forward rule effectively, understanding threshold income and adjusted net income is imperative.

• Threshold Income: From April 2023 the Threshold Income annual allowance has been set at £260,000 – after which your ability to make a pension contribution is restricted. For every £2 the taxpayers threshold income exceeds this limit, the taxpayers annual allowance is reduced by £1.
  
  How do I calculate my threshold income?
  
  The taxable income for the given tax year minus any taxable lump sum pension death benefits received during the same period as defined under section 636A-4ZA of ITEPA 2003. It also includes employment income that has been redirected towards pension contributions through a salary sacrifice arrangement initiated on or after July 9, 2015.
  
  From this figure, subtract the total amount of any pension contributions made through relief at source to ensure equal treatment between contributions made under net pay arrangements, which are deducted when calculating taxable income, and those made with relief at source.
  
• Adjusted Net Income: This encompasses total taxable income, including pension contributions (both employer and employee), and other taxable income. It is crucial for calculating the maximum contribution you are able to make in the year.
  
  The above figures are not always straightforward to calculate and HMRC regularly apply penalties (or charges) to those who unknowingly exceed their permitted annual contribution. To avoid falling fowl of these rules many taxpayers choose to use an accountant to advise here.

Illustrative Example of Carry Forward

Consider a scenario where John, a freelancer, earns £100,000 in 2023/24 and intends to maximise his pension contributions. His previous three years’ contributions were:

• 2020/21: £25,000 (Unused allowance: £15,000)
• 2021/22: £30,000 (Unused allowance: £10,000)
• 2022/23: £20,000 (Unused allowance: £20,000)

To calculate his available carry forward, John would sum the unused allowances from the preceding three years and add them to the current year’s allowance.

Total Carry Forward Allowance = Unused Allowance (2020/21) + Unused Allowance (2021/22) + Unused Allowance (2022/23) + Current Year’s Allowance =£15,000+£10,000+£20,000+£60,000 = £105,000

John has £105,000 of carry forward available, however because his “threshold income” (in this case his self-employed income) is £100,000, it is restricted to only being able to carry forward £100,000.

Example: Obtaining 40% Pension Relief

Imagine Sarah, a higher-rate taxpayer earning £60,000 per year. In the UK, the basic rate of tax is applied to income up to £50,270 (as of the 2021-2022 tax year), and the higher rate of 40% applies to income above this threshold up to £150,000.

Sarah decides to make a pension contribution of £8,000 from her gross income into her pension scheme. Pension contributions are made before tax is calculated, which reduces her taxable income. The process of obtaining 40% tax relief works as follows:

1. Gross Contribution: Sarah contributes £8,000 into her pension.
   
2. Tax Relief at Source: The pension scheme automatically claims tax relief at the basic rate of 20% directly from HMRC. So, the pension provider will add £2,000 to her contribution (£8,000 x 20% = £1,600, but as pension schemes claim 25% of the amount paid to make it up to the total, they add £2,000, making the total £10,000).
   
3. Claiming Additional Relief: Since Sarah is a higher-rate taxpayer, she can claim an additional 20% tax relief through her self-assessment tax return. This is calculated on the total gross contribution including what the pension scheme has already claimed.
   • The gross contribution is £10,000 (the £8,000 Sarah paid + £2,000 tax relief from HMRC).Sarah claims an additional £2,000 as higher rate relief (20% of the gross contribution of £10,000).
   Thus, the additional relief she can claim is £2,000, which she can receive either as a reduction in her tax bill or as a refund.
   
4. Effective Cost to Sarah: The actual cost to Sarah, after full tax relief, is only £6,000 (£8,000 paid out of her pocket minus £2,000 additional tax relief claimed), for a pension pot that grows to £10,000.

By making a gross contribution to her pension, Sarah effectively lowers her taxable income and saves on the tax she would have paid at the 40% higher rate on the amount contributed. This strategic use of pension contributions not only helps in building a retirement fund but also significantly reduces the immediate tax liability for higher-rate taxpayers like Sarah.

The 60% Tax Trap

An important aspect of pension tax relief is its role in mitigating what is known as the 60% tax trap. This situation arises when an individual’s income exceeds £100,000. At this income level, the personal allowance (the amount you can earn tax-free each year) begins to taper off.

For every £2 earned over £100,000, the personal allowance is reduced by £1. This creates an effective marginal tax rate of 60% on a portion of the income between £100,000 and £125,140, where the personal allowance completely phases out.

By making pension contributions, individuals can reduce their ‘adjusted net income’ and potentially keep their income below the £100,000 threshold, thus avoiding this tax trap.

Pension contributions are deducted from your income before the calculation of adjusted net income, effectively reducing taxable income and helping to preserve the personal allowance. This not only provides immediate tax relief but also strategically reduces the overall tax burden by avoiding higher marginal tax rates.

This means effective tax relief of up to 60% are available on contributions made at income levels between £100,000 and £125,140.

Conclusion

Understanding pensions can be tricky and therefore it’s important to take advice from a suitable qualified professional to ensure you do not fall foul of any tax rules surrounding them.

For more insights on pension planning and tax strategies tailored to your needs, please contact ESDG Accountancy, your trusted Chartered Accountancy practice.