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.