Tapered Annual Allowance - threshold and adjusted income

Pension annual allowance (AA) is the annual limit on the amount of contributions paid to, or benefits accrued in, a pension scheme before the member has to pay tax.

Tapered annual allowance is lower than the standard annual allowance. This lower limit may apply to any member, based on their level of taxable income within the tax year. 

Why the tapered annual allowance was introduced

In an attempt to control the cost of pensions tax relief and help make sure pensions tax relief is fair and affordable, from tax year 2016/17, a reduced annual allowance may apply to all pension savings by or on behalf of a member, depending on their level of taxable income within the tax year.

On 6 April 2016 the government introduced the Tapered Annual Allowance for individuals with “threshold income” of over £110,000 AND "adjusted income" of over £150,000.

As of 6 April 2020 the Tapered Annual Allowance applies for individuals with “threshold income” of over £200,000 AND "adjusted income" of over £240,000.

As of 6 April 2023 the Tapered Annual Allowance applies for individuals with “threshold income” of over £200,000 AND "adjusted income" of over £260,000.

What is threshold income?

Threshold income is one of two measures used to determine if a member has a tapered annual allowance.

Where an individual has a "Threshold income" of £200,000 or less they cannot be subject to the tapered annual allowance and there is no requirement to calculate adjusted income. If threshold income exceeds £200,000 you must calculate adjusted income to work out the amount of any tapered annual allowance.

The threshold income measure helps to provide certainty for individuals with lower salaries who may have one off spikes in the value of their employer pension contributions. If the individual’s net (taxable) income is no more than £200,000 they will not normally be subject to the tapered annual allowance. However, anti-avoidance rules will apply so that any salary sacrifice for pension savings set up on or after 9 July 2015 will be included in the threshold income calculation.

"Threshold Income" is broadly defined as ‘the individual’s net income for the year’. This will include all taxable income such as, 

• salary, bonus,
  
  
• pension income (including state pension),
  
  
• taxable element of redundancy payments,
  
  
• taxable social security payments,
  
  
• trading profits,
  
  
• income from property (rental income),
  
  
• dividend income,
  
  
• onshore and offshore bond gains,
  
  
• taxable payment from a Purchased Life Annuity,
  
  
• interest from savings accounts held with banks, building societies, NS&I and Credit Unions,
  
  
• interest distributions from authorised unit trusts and open-ended investment companies,
  
  
• profit on government or company bonds which are issued at a discount or repayable at a premium and income from certain alternative finance arrangements etc

less the amount of any taxable lump sum pension death benefits paid to the individual during the tax year that can be deducted from the threshold income.

For the process to calculate threshold income see Steps 1 and 2 of “The process for calculating adjusted income” detailed below.

In summary "threshold income" is: 

• Taxable income for the tax year less 
  
  
• Any taxable lump sum pension death benefits accruing in the tax year (ITEPA 2003 section 636A-4ZA) plus
  
  
• Employment income given up for pension contributions (i.e. salary sacrifice) under an arrangement made on or after 9 July 2015 less 
  
  
• The gross amount of any relief at source pension contributions (to ensure that when calculating threshold income, there is parity between any contributions made under net pay, which are deducted arriving at taxable income, and relief at source).

What is adjusted income?

Adjusted income is the other measure used to determine if a member has a tapered annual allowance.

The ‘adjusted income’ definition adds in the value of all employer pension contributions, to prevent individuals from avoiding the restriction by exchanging salary for employer contributions. For those in defined benefit or cash balance arrangements, the value of the employer contribution will be calculated using the annual allowance methodology. That is the employer contribution will be the total pension input amount for the arrangement, less the monetary amount of any contributions made towards that arrangement by the member during the tax year.

The process for calculating adjusted income

1) Identify the amounts of income on which the taxpayer is charged to income tax for the tax year. The sum of those amounts is "total income". Each of those amounts is a "component" of total income (components of this income will include all taxable income as covered previously). This is Step 1 in the calculation section of the Income Tax Act 2007.

2) Deduct from the components the amount of any relief under a provision listed in relation to the taxpayer in section 24 to which the taxpayer is entitled for the tax year. See section 25 for further provision about the deduction of those reliefs. The sum of the amounts of the components left after this step is "net income" . This is Step 2 in the calculation section of the Income Tax Act 2007. Also for more information on the reliefs which are deductible, see the Income Tax Act section 24 and section 25.

3) Add the amount of any pension contributions:

• Under Net pay arrangements
  
  
• Gaining UK tax relief but made to overseas pension schemes
  
  
• Using Excess relief under net pay provisions
  
  
• Using relief on making a claim provisions

4) Add the value of employer contributions, which are:

• Money Purchase = value of contributions
  
  
• Defined Benefit = Pension Input Amount minus member contributions (technically you have to add in the total pension input amounts and subtract the member contributions but this amounts to the same thing and is simpler) 

5) Subtract the amount of any taxable lump sum pension death benefit paid to the individual in that tax year

Note: where members only have defined benefit pension provision and employment income the adjusted income can be calculated by simply adding the annual allowance used in the scheme to the P60 earnings

How the taper works

Where both the adjusted income and threshold income have been breached then the rate of reduction in the annual allowance is by £1 for every £2 that the adjusted income exceeds £260000, up to a maximum reduction of £50,000, down to a minimum tapered annual allowance of £10,000.

This results in the standard Annual Allowance being available for those with an adjusted income of less than £260,000; a reducing Annual Allowance for those with adjusted incomes between £260,000 and £360,000 and an Annual Allowance of £10,000 for those with an adjusted income over £360,000.

The Tapered Annual Allowance limits apply to both Defined Contribution and Defined Benefit pension input amounts. Although the value of "contributions" is easily identifiable within Defined Contribution type schemes, it is not as straight forward with Defined Benefit schemes. However, the DB calculation method is explained in the Annual Allowance for pension savings article. When assessing against the above limits it is the combined total of all pension "contributions" that need to be considered.

Those subject to a Tapered Annual Allowance will still be able to carry forward unused allowance from previous tax years.

Tapered Annual Allowance and carry forward

From its introduction in the 2016/17 tax year to the 2019/20 tax year the tapered annual allowance operated under different limits. The threshold income limit was £110,000, the adjusted income limit was £150,000 and the minimum tapered annual allowance was £10,000 (meaning that the minimum taper applied from adjusted income of £210,000 and above).

From the 2020/21 tax year until the 2022/23 tax year the threshold income limit was £200,000 and the adjusted income limit was £240,000.

It is important to know these limits when looking to work out the members carry forward position even if no pension contributions have been made the tapered annual allowance would still have effect for those tax years.

Tapered Annual Allowance Planning

If clients are impacted by the taper then some planning may be done which could alter the impact of the taper. This area is considered in detail in our article Tapered annual allowance: planning ideas and potential pitfalls.

If clients have breached the tapered annual allowance, also consider if carry forward can be used to reduce or absorb the annual allowance excess amount. Where a Tapered Annual Allowance (TAA) applies in a tax year, it is only the unused TAA amount that can be carried forward from that tax year. Having a nil pension input amount does not mean you carry forward the full standard annual allowance. For high income clients, you still need to work out any TAA limit before you can calculate available carry forward of unused annual allowance.

If there is still an excess amount then more information about how the relevant tax charge is calculated, reported and paid is in our article Annual Allowance for pension savings.