What is my annual pension allowance and how can I avoid paying tax?

The healthcare industry has to contend with constant change and strict compliance regulations. In this series of three blogs, Chadwick’s Director and specialist medical accountant, Nigel Birtwistle, explores some of the common queries we regularly advise on. Nigel’s first blog tackles the annual pension allowance; exploring how earnings are calculated and how to plan your retirement to mitigate your tax liability.

Your annual pension allowance is the amount you can pay into all pensions in a tax year. If you are a high-grossing doctor or you have income in excess of £200,000, you may have an issue and not even realise it. If you have exceeded your annual allowance, you will be taxed on the excess.

1. How much you need to earn before incurring a pension tax charge

How much your pension is taxed depends on your threshold income, plus your adjusted income. Your threshold income is your total net income for the year, whilst adjusted income is your total income plus the value of all employer pension contributions.

You will not be subject to tapering of the pension allowance and get your standard allowance of £40,000 per annum if the following criteria are met:

• Your threshold income is below £200,000 or
• Your threshold income is above £200,000 and your adjusted income is less than £240,000.

Alternatively, if your threshold income is above £200,000 and your adjusted income is above £240,000, then your annual pension allowance will be subject to tapering and a pension tax charge.

2. How your earnings are calculated

Threshold income is, in effect, your net total income for the year. Included in your threshold income calculation is:

• Salary
• Benefit in kind
• Bonuses
• Dividend income
• Interest on savings
• Rental income
• State, occupational and personal pension income
• Earnings from self-employment and partnerships
• Income received by an individual by trust.

Deducted from this total are gross relief at source personal pension contributions.

Adjusted income is your total income plus the value of all employer pension contributions.

When calculating if you have to pay the pension charge, you also need to calculate if you have any unused allowances from the previous three years. You only pay the tax charge if you have insufficient carry forward allowance to offset the excess over the limit. If you have exceeded the limit, then you are taxed on the excess at your marginal rate of taxation.

3. How the tax charge is calculated

If both your threshold and adjusted income exceed their limits and you still have an excess after using up any unused allowances from the previous three years, your annual pension allowance of £40,000 is reduced for each £2 adjusted income exceeding £240,000 by £1.

If your adjusted income is £312,000 and above, the annual pension allowance will be reduced to £4,000 per annum.

For example, if your pension contributions for 2020-2021 were £75,000. If the threshold income is £210,000 and the adjusted income is £275,000 and there are no unused allowances from the previous three years your tax charge will be:

£275,000-240,000= £35,000.

£35,000/2 = £17,500.

The annual pension allowance is reduced to £22,500 (£40,000-£17,500).

The excess pension contributions are £75,000-£22,500 = £52,500.

Taxed at marginal rate of 45% = £23,625 tax charge.

4. If your pension scheme can pay any pension tax due

If the tax charge is greater than £2,000 you can ask your pension scheme to pay this on your behalf.  Your scheme will make the payment in return for the appropriate reduction to your NHS benefits:

• Money purchase scheme – the pension fund is reduced by the tax charge and any early withdrawal charges which may apply.
• Final Salary scheme – the scheme calculates the reduction in benefits, but this always has to be just and reasonable.

‘Scheme pays’ is a mechanism by which your annual allowance charge can be paid out of your pension scheme, rather than by you personally. This means that you don’t have to find additional funds to pay the charge.

An election needs to be received by the scheme administrator by 31 July following the January in which the annual charge is declared on your self-assessment return. For example, for the tax year 2020-2021, the deadline would be 31 July 2022.    

It is your responsibility to ensure your pension scheme makes the payment on your behalf and if not, you must make the payment personally.

If your liability is less than £2,000 you can request your pension scheme to make the payment on your behalf, but they don’t have to.

We are here to help

We can help you check your pensions for annual allowance breaches and advise the best way to plan your retirement to mitigate your tax liability. If you would like to speak to one of our specialist medical accountants about pensions or any other financial matter, then please do not hesitate to get in touch.

You can also read more about us and our services here. You can also email or call us on 0161 370 9600.