Restrictions to pension funding are one of the key frustrations facing financial planners today. A recent survey by abrdn found that two thirds of advisers surveyed included either the tapered annual allowance or the money purchase annual allowance in the top three things that they would like to see reformed to help their business and clients.

Pensions are the best place for clients to save for their retirement, with the tax breaks on offer likely to provide more spendable cash in retirement than the main alternatives invested on a like for like basis.

However, for some this premise could be challenged if a client pays in more than their annual allowance and incurs an annual allowance tax charge. And many clients faced with a tax charge may either cut the amounts being saved or the turn their back on pension saving completely.

But the annual allowance tax charge on its own should not be an automatic trigger to stop saving and for certain clients, pension funding remains an attractive option despite the tax charge.

Impact of the annual allowance

The annual allowance is the way HMRC limits the amount of tax relieved pension savings that can be made for an individual each tax year.

The allowance has been frozen at £40,000 since 2016/17, though it can be lower - all the way down to £4,000 - for high earners subject to the tapered annual allowance or for those who have flexibly accessed their defined contribution (DC) pension and become subject to the money purchase annual allowance (MPAA).

The number of people having to pay the tax charge has increased year on year from just 5,460 in 2015/16 to 42,350 in 2019/20*, with the introduction of the tapered annual allowance in 2016/17 no doubt being a factor. The income levels at which the taper takes effect were raised in 2020/21, reducing the numbers of high earners that might be affected, although the benefit of this could begin to be reversed to some extent by the potential for wage inflation given the current economic backdrop.

The cost of the annual allowance charge has been cited as a reason for doctors within the NHS reducing their hours, turning down promotions, or even taking early retirement as the tax charge bites into the benefit of remaining a member of the pension scheme.

How does it work?

It's possible to exceed the annual allowance in a tax year and still avoid any penalties by carrying forward any unused allowance from the previous three years, though it's not possible to do this to cover DC contributions over the MPAA.

If the annual allowance is exceeded and there's no unused allowance to carry forward to cover the excess, then that amount will be subject to the annual allowance tax charge. Regardless of who paid the contributions, the charge is a liability of the scheme member themselves and the amount due is based on the individual's marginal tax rate.

The individual can either pay the charge themselves, in which case it should be made in accordance with the normal self-assessment deadlines for the tax year to which the charge relates, or it may be possible for the scheme to pay the charge on the member's behalf, deducting it from their DC fund or making an adjustment to the accrued pension under a DB scheme.

The effect of the charge is to remove the tax relief that the member would have been entitled to had they made the contributions themselves.

Is there still a benefit to paying in when above the allowance?

Clients should only consider giving up saving into their pension if there is a better alternative. If the net returns on pension savings (including employer contributions) are still greater than saving alternatives elsewhere then an annual allowance charge may be a price worth paying.

Any client faced with the prospect of exceeding their annual allowance has some difficult decisions to make and the best course of action will depend on their individual circumstances:

• Should they give up their employer pension contributions?
• Does carrying on paying matching contributions make sense?
• If their employer offers extra salary in exchange for pension contributions, will they be better off taking this and investing it elsewhere?

Employer funding

Clearly, one of the key elements influencing choice will be the value of the employer contribution, which might also depend on the employee making contributions. Many employers offer matching contributions. So if your client stops funding, will their employer stop funding too?

Employer pension contributions are essentially 'free money'. Even if they suffer the highest level of annual allowance charge at 45% (or 46% in Scotland) on their entire amount, clients should still be better off as they're receiving 55% (or 54%) of something they would otherwise miss out on. It may therefore make financial sense for most to continue their own funding to retain the funding from their employer, despite the charge.

Obviously if new contributions could also lead to a LTA charge then this should also be taken into account. Where an employer recognises both the possibility of an annual allowance tax charge and/or a lifetime allowance tax charge, they may offer some alternative form of benefit instead of the employer pension contribution, such as extra salary.

The amount of extra salary offered is likely to take into account that the employer will have to pay employer NI on it. The salary received by the individual would of course suffer income tax and employee NI, but the net amount invested in a non-pension alternative may prove more attractive. However, it should be remembered that such investments could be subject to tax on the income and gains (unless held in an ISA wrapper) as well as IHT if they're still in the client's estate at the date of death.

Self-employed

The existence of a relatively generous employer pension contribution may mean that continuing to fund a pension is still a rational decision. But what about the self-employed?

Ultimately, these decisions depend on individual circumstances, both at the time of making the contribution and at the point of withdrawal in retirement.

Summary

The annual allowance tax charge is there to limit the tax breaks from contributions over the allowance. The decision to make contributions above the annual allowance will very much depend on a client's current and likely future circumstances. But the possibility of an annual allowance charge is not necessarily a signal to stop contributions, particularly where there's an employer contribution on offer but no alternative benefit.

Other investments for a client's own money may provide a better outcome in some circumstances. It should, however, be remembered that pensions offer benefits over and above tax relief on contributions, such as tax-free growth and IHT protection, and these benefits should also be taken into account.

* https://questions-statements.parliament.uk/written-questions/detail/2022-04-20/156620