Why larger pension contributions can have a significant impact
Pensions are a crucial component of financial planning, particularly for individuals seeking to secure a comfortable retirement. For some, increasing pension contributions can be a strategic move to make up for missed savings or to maximise tax-efficient benefits. However, understanding the rules around contributions requires careful consideration to avoid potential pitfalls.
Large contributions can assist individuals who have delayed pension saving due to cost concerns or competing financial priorities. They are also attractive for those looking to transfer significant funds into a tax-efficient account. However, there are annual limits to consider, and understanding how these operate is essential to avoid unnecessary charges.
How pension contributions work
When you contribute to a pension plan, your contributions benefit from tax relief. For personal pensions, such as a Self-Invested Personal Pension (SIPP), your provider claims 20% tax relief from HM Revenue & Customs (HMRC). If you are a higher or additional rate taxpayer, you can claim additional relief through your self-assessment tax return, which can significantly reduce your overall tax bill.
Another advantage is that your investments grow tax-free as long as they remain within the pension. Investment income, interest, and any gains are exempt from taxes. However, remember that once you start withdrawing from your pension, income tax will be applicable, except for the current first 25% (often called the tax-free lump sum), up to a maximum of £268,275.
Understanding your annual allowance
Pension contributions that qualify for tax relief are subject to limits. Usually, this is capped at the higher of 100% of your UK taxable earnings or £3,600 (including tax relief). There is also an annual allowance that limits how much you and others can contribute across all your pensions each tax year without incurring additional taxes.
For the 2025/26 tax year, the annual allowance is set at £60,000. For defined contribution pensions, this allowance is straightforward to calculate; it includes your contributions, tax relief, and any payments made by employers or third parties. However, for final salary or defined benefit pensions, the situation is more complex. The annual increase in the pension’s capitalised value over the tax year is used as the benchmark, and your scheme administrator can perform this calculation.
Impact of tapered allowances
High earners might face a reduced annual allowance, known as the ‘tapered allowance’. This applies if your threshold income exceeds £200,000 and your adjusted income surpasses £260,000. It could reduce your annual allowance to as little as £10,000, depending on your earnings and employer contributions.
After retirement, opting for flexible access to your pension, such as through drawdown, triggers the Money Purchase Annual Allowance (MPAA). This limits your annual contributions to just £10,000. Recognising these restrictions is crucial to avoiding tax penalties on excess payments.
Carry forward unused allowances
If you haven’t used your full annual allowance in previous tax years, you may be able to carry forward unused portions to make larger contributions now. This rule allows you to access unused allowances from the past three tax years, giving you the opportunity to ‘catch up’ on missed contributions.
Carry forward is particularly helpful for self-employed individuals with fluctuating incomes or those expecting large contributions from a windfall, such as an inheritance or the sale of a business. However, the process has certain requirements. For example, you must have been a member of a UK-registered pension scheme in previous years, and your earnings in this tax year must support the contribution amount you plan to make.
Planning for employer contributions
For business owners, there is greater flexibility when making contributions through a company. Employer contributions are permitted up to the individual’s annual allowance and carried forward amounts. Importantly, these payments do not need to be connected to taxable income. However, contributions must satisfy the ‘wholly and exclusively’ test, ensuring they are reasonable in relation to your role and salary.
Remember that in previous years, the annual allowance was lower, limited to £40,000 until the 2023/24 tax year. Also, any reductions due to the tapered annual allowance must be included. These details emphasise the complexity of correctly applying carry-forward rules.
Monitor your tax position
Exceeding your annual or carried forward allowances has consequences. Any excess contributions lose their tax relief and are subject to a tax charge. It is your responsibility to report this to HMRC and pay the required charges through your self-assessment tax return.
Considering the complexities involved, from the MPAA to implementing rules, seeking professional advice is crucial. Whether you want to optimise your contributions or understand personalised strategies, we can guide you towards making the most of your pension.
Need professional guidance with your retirement plans?
Contributing more to your pension can greatly enhance your retirement savings, but the process might seem daunting. If you require advice specific to your situation or help with HMRC rules, contact us today. Taking charge of your pension savings now can help secure your financial future.
THIS ARTICLE DOES NOT CONSTITUTE TAX, LEGAL OR FINANCIAL ADVICE AND SHOULD NOT BE RELIED UPON AS SUCH. TAX TREATMENT DEPENDS ON THE INDIVIDUAL CIRCUMSTANCES OF EACH CLIENT AND MAY BE SUBJECT TO CHANGE IN THE FUTURE. FOR GUIDANCE, SEEK PROFESSIONAL ADVICE. THE VALUE OF YOUR INVESTMENTS CAN GO DOWN AS WELL AS UP, AND YOU MAY GET BACK LESS THAN YOU INVESTED.
