Pension tax charges swell: how to avoid getting caught out

HM Revenue and Customs (HMRC) has published its private pension statistics for 2023, and the data has uncovered some worrying trends for retirement savers.

Among the most eye-catching is the trajectory of charges for breaching certain pension allowances, with HMRC scooping up more in heavy tax penalties than ever before.

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On a brighter note, the allowances in question became more generous in April 2023. This means that if you know where you stand and plan effectively, you should be able to maximise your pension savings without being stung by the taxman.

Here’s what you need to know.

Annual allowance uplift

The annual allowance (AA) is the amount you can save into a pension every year and get pension tax relief. This includes personal contributions plus any from your employer and any third parties. Under current rules, the limit is the lower of 100% of earnings or £60,000, a sizeable uptick on the £40,000 limit imposed until April 2023.

So, if your income is £50,000 a year, that’s your AA. But if you earn £70,000, your AA is £60,000.

If you breach the limit, you face a charge – the amount you exceed it by is added to your income for the year in question and becomes taxable, effectively wiping out the valuable up-front tax relief you would’ve gained from paying that sum into a pension. However, the charge doesn’t apply if you’re retired and took all your pension pots due to serious ill health.

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The total value of AA charges reported by pension schemes for the 2021-22 tax year was £335 million, a 65% jump on the £202 million paid the year before – this figure includes the tapered annual allowance and money purchase annual allowance, which I explain below. The new higher allowances should reverse this trend for future tax years, but you still need to be aware of them.

Boost for big earners

If you’re lucky enough to earn a big salary and pocket more than £260,000 a year, your AA may reduce to as little as £10,000. This is called the tapered annual allowance, or taper for short.

So, how does the taper work? For every £2 you earn above £260,000, your £60,000 AA reduces by £1. The taper halts at £10,000 once income hits £360,000.

Prior to April, the taper was just £4,000, so while it’s still significantly lower than the standard AA, it’s much more generous than in previous years.

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What’s more, the combination of the higher minimum taper, coupled with the increased AA, has given higher earners more scope to save into a pension and get tax relief as the table below shows. For reference, adjusted income refers to your taxable earnings plus any employer pension contributions you receive:

Bigger allowance for retirees

If you’ve started to draw from your pension pot, you might also face restrictions on what you can pay into a pension and save tax. This is known as the money purchase annual allowance (MPAA), and once triggered pares back your AA to £10,000. Again, the 100% earnings rule applies.

But like the taper, the MPAA also went up from £4,000 in April, giving you some extra room to save. It typically applies to those of you who previously retired but have recently returned to work and want to beef up your pension savings.

So, what normally triggers the MPAA? Well, there are a handful of events. If you start to draw lump sums; begin taking income using income drawdown; or if you buy an investment-linked annuity (an income-generating product for life where the income can go up or down based on investment performance).

Interestingly, you won’t trigger the MPAA if you buy a level or increasing annuity, or merely take your tax-free lump sum from your pension but don’t draw any income.

If you’re a retiree that’s resumed work this year, it’s important to check whether you are restricted by the MPAA.

Carry forward if you can

In some instances, your AA could be more than £60,000. Under carry forward rules, you can tap into any unused allowances from the past three tax year years. This means that you could pay up to £180,000 into a pension before April and get tax relief on the lot - though the 100% of earnings rule still applies.

That’s because your maximum AA is £60,000 this year and you might be able to bring forward £40,000 in each of the previous three tax years.

To qualify, you must have belonged to a workplace or private pension during the years you wish to carry forward and you can only use any unused allowances once. And don’t forget about the taper, which might apply to both the current tax year and any previous, potentially reducing what you can carry forward.

The carry forward rules might be useful for those of you who are approaching retirement and want to supercharge your later-life savings.

Lifetime limit no more

Prior to April, the Lifetime Allowance (LTA) was a major headache for a growing number of pension savers, with anyone who breached it hit with heavy tax charges once benefits were drawn. And with the LTA barely budging since the 2017-18 tax year, more and more people had been falling foul of it.

HMRC figures show LTA charges hit £497 million in 2021/22, 27% higher than the £391 million registered in 2020-21.

But Jeremy Hunt’s bombshell policy decision in his 2023 Spring Budget was to give the LTA the elbow.

The chancellor’s move will have been a bitter pill to swallow for those who paid LTA charges in previous years, as my colleague and interactive investor’s head of pensions and savings, Alice Guy, notes: “The rule changes were a complete surprise and many wealthy pensioners will be absolutely gutted to have triggered a 55% penalty, just months before the rules changed.”

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The LTA capped lifetime pension savings at £1.07 million. Any excess drawn as income was charged at 25% (as well as any income tax you would inevitably pay) and if you took it as a lump sum a mammoth 55% tax charge applied.

While the LTA is still effectively in place this year, the charge for exceeding it has been removed, and it will officially be canned in April 2024. The one sting in the tail is that the maximum you can take in tax-free cash has been capped at £268,275.

The LTA's removal is great news for savers who are yet draw their pensions, as not only did the LTA mean you had to be careful about what you paid in, but also penalised you for investing wisely. But you can now save and invest freely without the worry of facing a heavy tax charge down the line.

What to take away

For most of you, staying within the confines of the various pension allowances shouldn’t be too much of a problem. Few have the financial resources to commit either 100% of earnings or £60,000 into a pension in any given tax year.

But for those threatening to rub up against the AA, either because your earnings are high or you’re already using income drawdown, the key here is to know where you stand. Also make sure you factor in any employer contributions when calculating your allowance.

One of the biggest attractions with pensions is the up-front tax relief on offer, so it’s vital to keep within the limits to make the most of your retirement savings.

As you may have found, the pension landscape can be complicated at times. If you need a bit of help, then it’s worth seeking professional advice.