Auto enrolment and the pension contributions tax trap

Auto-enrolment has made sure that an ever-growing number of people across the UK have a pension. But the latest increase in contribution levels, coupled with the Annual Allowance restrictions on how much you can save ‘tax efficiently’ into a pension each year, means that some higher earners are now caught in a contributions trap and – often unknowingly – facing a 45% tax on their pension savings.

The Government’s Auto Enrolment initiative requires every UK employer to put their qualifying staff (those aged between 22 and State Pension age, earning over £10,000 a year and working in the UK) into a workplace pension scheme, to which both employer and staff contribute.

Until this year, the total minimum contribution level was 5% – with a 3% minimum employee contribution, and 2% from the employer. But as of April 2019, this minimum contribution has increased to between 7% and 9% of an employee’s earning (depending on the salary used to calculate contributions).

At the same time, the pensions Annual Allowance restricts the number of contributions that you can make into a pension each year and still earn tax relief. For those with a total ‘adjustable income’ (your total taxable income) up to £150,000, the allowance is £40,000. But for total adjustable income above this amount, the Tapered Annual Allowance (TAA) kicks in; between £150,000 and £210,000, you lose £1 of allowance (starting at £40,000) for every £2 of adjusted income. Once your income reaches £210,000, you’ll be left with a TAA of £10,000. Any pension contributions over this amount are likely to result in a tax charge of up to 45%.

The restrictions are even tighter for anyone who has taken money out of their pension but is still looking to make contributions and earn tax relief. In this situation, the Money Purchase Annual Allowance (MPAA) applies; until 2017 this also provided an allowance of £10,000 each year. But that was cut in the 2017-18 tax year, and the MPAA now sits at just £4,000.

The following example shows the impact of the contribution increases on someone affected by the tapered annual allowance:

In recent months we have highlighted this fact to a number of unaware clients who have a handful of employees affected by this issue, and we know they are not alone.

What can be done?

There are four main options for anyone who finds themselves affected in this way by the contributions increase.

Reduce contributions – by reducing the contributions to below the annual allowance, a tax charge can be avoided. This would represent a reduction in an employee’s remuneration package, which would, therefore, need to be compensated for in some way.

Change the basis of salary – by calculating contributions on qualifying earnings (the band between £6,032 and £46,350), contributions will fall below both the TAA and MPAA. Again, this is a reduction in remuneration will need compensating for.

Use carry forward – while this can be done for the TAA (although the taper may have been in place for nearly three years now), it’s not possible to use ‘carry forward’ to enhance the MPAA.

Do nothing – pay the contributions and the resulting tax charge. This will undoubtedly be the default approach, but it’s unlikely to be the most efficient.

While this issue will not impact everyone, it does highlight the need – both as an employer and an individual – to explore all the options when it comes to tax-efficient investing. If you would like to find out more, please contact us using the form below.