“How much can I put into my pension this year?” sounds like quite a simple question, doesn’t it? Often, though, our job is to point out that a question that quite reasonably seems straightforward is not. This is often one of them!
One of the overarching concepts with pensions is the Annual Allowance. This is generally thought of as “how much can I contribute to my pension each year?”. But it’s not as simple as that. A better way of thinking of it is “what’s the most money that is allowed to make its way into my pension pot this year?”. Because personally contributing isn’t the only way money can get into your pension. There are really three:
- You can make a contribution personally into your own pension scheme (by, for example, contributing to a personal pension or an Automatic Enrolment one - a Defined Contribution scheme, where there's a visible pot that's yours; the vast majority of pensions these days).
- Your employer (which might be your own limited company) can similarly make a contribution into a scheme.
- If you’re in a Defined Benefit scheme, where there’s no discrete personal pot of savings but your employer promises to pay you a pension once you retire, from their pension fund as a whole, then your employer can increase the pension it promises to pay (this happens a lot with NHS consultants, whose promised pension increases each year with longevity and seniority). That’s deemed to be an increase of a notional pension pot, counting towards the Annual Allowance and the employer must quantify it for you.
Fundamentally, we all have an Annual Allowance of £40,000, and that's the total cap on those three things put together. But there are still complications:
- The Annual Allowance is reduced if your income for the year is over £240,000 (previously £150,000).
- If you’ve not used up all your Annual Allowance in the previous three years, that’s usually added to this year’s allowance too. So, in an extreme case someone could have £160,000 legitimately make its way into their pension funds this year.
We’re not done, though. The Annual Allowance is simply a ceiling on what can go in by one route or another. But there are separate limits on what can go into personal pension funds via those first two routes:
- Although anyone can contribute up to £3,600 to a personal pension in a tax year, above that the amount you can contribute personally is capped at your “Relevant Earnings” - basically, your income from a PAYE job or an unincorporated business. So even if someone has Annual Allowance of £88,000 available because they’ve got some unused AA from earlier years, if their income for this year is £42,000 via PAYE then the maximum personal contribution they can make is £42,000 (even if they’ve loads of spare cash beyond that). Directors on a small salary therefore can't pay much into their pension personally. (It’s also important to remember that personal pension contributions are made net of basic rate tax, so if that person wants to contribute £42,000, they’ll actually hand over £33,600 to the pension company, who’ll get the other £8,400 from the government).
- The amount your employer can pay into your pension needs to be justifiable in terms of the total “package” you get from them (otherwise it’s not a legitimate deduction against tax for them). If your employer is just a third party, that’s going to be the case automatically; the whole reason they’re giving you that salary, pension contribution etc is because they think it’s an appropriate economic bargain for your services. When it’s your own company it needs more thought. If you work through your own company, is it reasonable for your company to put £40,000 into your pension? Generally, yes. It’s likely that, in conjunction with the small salary you’re getting, the total package wouldn’t be considered excessive, as you seem to be generating enough value for the company that it can afford the package. So this is how most director-shareholders fund their pension; their contributions aren’t capped at their small salary, because they’re not making personal contributions. Would it be reasonable for the company to make a similar payment into the pension of a non-working spouse? No. If they’re not working for the company, the appropriate employment package for them would be zero.
It’s even harder if you’re in a defined benefit scheme - you won’t know about the deemed increase in your pot until after the year-end, at which point it’s too late to make any further contributions for the year! The uplift might be less than you thought, and you’d have liked to have put another £5,000 into another personal pension you have - unlucky! The unused Annual Allowance will have been carried forward to use in the next year, though (if income and so on permits). Or the uplift might be more than you thought, taking you over the Annual Allowance you have available - in which case you've tax to pay.
Pensions are pretty simple for many, but not for everyone!