Pensions contributions – a great way to save money and cut your tax bill

Increasing your pension contributions is an effective way to reduce the amount of tax that you pay each year, while also helping you to save more for retirement.

But savers need to ensure that they do not exceed the UK’s pension allowances so that payments made into a pension scheme are tax-free.

The Annual Pension Allowance 

The annual pension allowance places a limit on the total amount of contributions that can be paid into defined contribution pension schemes and the total amount of benefits that you can build up in defined benefit pension schemes each year, tax-free.

The limit for most taxpayers is currently capped at £40,000 per year, although a reduced allowance of £4,000 may apply to those who have already begun accessing their pension. 

This allowance applies across all of the schemes that a taxpayer holds, it is not a ‘per scheme’ limit and includes all of the contributions that you or your employer pay or anyone else who pays on your behalf.

If you have not made full use of the annual pension allowance in previous years, then you can bring forward any unused annual allowances from the previous three tax years.

The Money Purchase Annual Allowance

The money purchase annual allowance (MPAA) applies if you have used flexible pension benefits and you want to continue paying contributions to a defined contribution pension scheme.

This includes both your own contributions and any other contributions paid on your behalf, such as by an employer or a third party. 

If this is the case, then a reduced allowance of £4,000 per year applies where you have withdrawn more than the 25 per cent tax-free pension commencement lump sum.

You cannot bring forward any unused annual allowances from the previous three tax years to warrant a higher contribution than £4,000 towards your defined contribution benefits.

The MPAA only applies from the day after you have taken flexible benefits and so any previous savings are not affected. 

Lifetime Pension Allowance

The current lifetime allowance for most taxpayers is £1,073,100 (2022/23). This allowance applies to the total of all the pensions you have, including the value of pensions promised through any defined benefit schemes, but excluding your State Pension.

The allowance is calculated by comparing a payout from your pension schemes, against your remaining lifetime allowance to see if there is additional tax to pay.

You can, therefore, work out whether you are likely to be affected by adding up the expected value of any payouts you are due to receive.

If the cumulative value of the payout from your pension pots, including the value of the payout from any defined benefit schemes, exceeds the lifetime allowance, there will be tax charged on the excess – called the lifetime allowance charge.

The way the charge applies depends on whether you receive the money from your pension as a lump sum or as part of regular retirement income, such as an annuity. 

The Tapered Annual Allowance

It is very important that high earners are aware of the tapered annual allowance (TAA). The tapered annual allowance further limits the amount of tax relief high earners can claim on their pension savings by reducing their annual allowance to as low as £4,000. This reduced allowance could change from tax year to tax year depending on your income.

This rule means that for every £2 of ‘adjusted income’ above £240,000 per annum (gross income including pre-pension contribution earnings, savings and pension income, as well as the value of any other pension contributions), £1 of annual allowance will be lost. 

This ‘tapering’ stops at £312,000, so everyone will retain an allowance of at least £4,000. If you have earnings of £200,000 per annum (post-pension contributions), known as ‘threshold income, the TAA will not affect you.

If the TAA affects you, you will still be able to carry forward unused annual pension allowance from previous tax years provided you had an open pension those years. 

Want advice on using pensions to reduce your personal tax bill? Speak to us today.