Accounting for the Annual allowance charge
Notifying HMRC that they are liable for an AA charge can be a daunting prospect for clients, but advisers can provide the helping hand.
The annual allowance (AA) is a mechanism for restricting the tax relief available on pension savings with any ‘excess’ tax relief being recouped via the associated charge. It should be noted that the restriction on the amount of tax relief does not apply when the pension savings are made and any tax relief due is claimed in the normal way. Instead, the AA works by applying a tax charge when ‘chargeable amount’ is identified in a tax year.
Where the money purchase annual allowance (MPAA) is not a consideration, then in a tax year an individual will have a chargeable amount if their pension input amount (PIA) for that year exceeds their AA, plus any carry forward of unused AA from the three previous tax years. Tapering of the AA may be an additional consideration. The availability of unused AA from a previous tax year depends on the individual being a member of a registered pension scheme at some point in that tax year, and their PIA being less than their AA in that year. Member in this context includes: active, deferred, pensioner and pension credit member.
The PIA for an arrangement under a registered pension scheme is determined in accordance with the relevant legislation, and in effect is a measure of the increase in pension savings made by the individual in the tax year under the arrangement.
Determining whether individuals who have triggered the MPAA have a chargeable amount in a tax year is increasingly complex and detailed, so I will not be covering it here. However, if a chargeable amount has been identified for an individual, they will have an AA charge to account for in the tax year. The first step in quantifying the amount of the charge is to ascertain the individual’s ‘reduced net income’ for the tax year.
Generally speaking, reduced net income is the amount on which the individual will actually pay tax for the year. Legislation defines it as the amount found after step 3 of section 23 Income Tax Act (ITA) 2007. This is after the individual has:
• Identified their total income
• deducted any reliefs allowed for under section 24 ITA 2007
• deducted any allowances to which they are entitled for the tax year under Chapter 2 of Part 3 of ITA 2007 (individuals: personal allowance and blind person’s allowance).
Calculating the AA charge
Any chargeable amount for the tax year is added to the individual’s reduced net income for that year. The portion of the chargeable amount:
• over the higher rate limit will be taxed at 45%
• over the basic rate limit but below the higher rate limit will be taxed at 40%
• below the basic rate limit will be taxed at 20%
For Scottish taxpayers, the rates above are replaced with the ‘Scottish main rates’ equivalent.
To illustrate how this works in practice, consider the following example:
Diego’s reduced net income for 2018/19 was £150,000 and he had a chargeable amount of £30,000 for the tax year. In the tax year his personal contributions totaled £20,000 gross and his relevant UK earnings in the tax year exceed that amount. Tax relief on these contributions was available on the whole amount through relief at source. He is not a Scottish taxpayer.
Diego has no personal allowance, and the basic rate tax and higher rate tax limits applicable to him for the tax year were £54,500 (£34,500 + £20,000) and £170,000 (£150,000 + £20,000) respectively.
Reduced net income plus chargeable amount = £150,000 + £30,000 = £180,000
£20,000 @ 40% = £8,000
£10,000 @ 45% = £4,500
Total AA charge = £12,500
The responsibility rests with the individual to inform HMRC if they are liable for an AA charge. This will normally be done using the additional information pages contained in their Self-Assessment tax return. Meeting this responsibility may be a daunting prospect for individuals, even more so if tapering and/or the MPAA are applicable, so they will likely turn to their financial adviser for guidance.
The consequences of not meeting the challenge presented by this aspect of pension tax legislation are likely to be critical for both advisers and clients. In the case of clients, the ramifications are financial in nature and ultimately will have a bearing on their retirement planning. For advisers, their reputations and the trust of their clients are at stake.
This article was originally published in Money Marketing