ATXP6 UK
Syllabus A1. Income tax A1a. The use of exemptions and reliefs in deferring and minimising income tax liabilities

A1a. Pensions

Syllabus A1a)

B7 The use of exemptions and reliefs in deferring and minimising income tax liabilities

Types of pension schemes

Occupational pension schemes

These are pension schemes that are run by an employer. 

An employee can contribute into the scheme and an employer can contribute into the scheme on behalf of the employee. 

If an employee contributes into the scheme, tax relief is given as follows:

  • The contribution made by the employee is deducted from their salary in arriving at taxable income. 

    It is basically treated as an allowable expense.

Illustration 1:

David has a salary of £20,000.

During the year he has contributed £1,000 into his occupational pension scheme.

  • What is his taxable income?

Solution:

Salary £20,000
Less:
Pension contribution (£1,000)
Net income     £19,000
Less:
Personal allowance (£11,850)
Taxable income £7,150

Registered personal pension schemes

Any individual (whether employed or not) can join a Personal pensions scheme.

It is run by banks, insurance companies or other financial institutions.

Stakeholder pensions are a type of personal pension scheme. 

They must satisfy certain rules, such as maximum level of charges and ease of transfer.

There are 3 tax benefits available for making personal pension contributions into a registered scheme. 

They are exactly the same as the tax benefits available for making gift aid donations. 

These are:

  1. Pay net of 20%. 

    For example, if an individual want to make a personal pension contribution of £1,000, he needs to pay 80% and HMRC will make the remaining 20% contribution on his behalf. 

    Therefore, he will pay £800 and HMRC will pay £200 to the fund.

  2. Therefore, this same individual will increase his basic rate band to £35,500 and his higher rate band to £151,000.

    This will result in an additional £1,000 being taxed at the lower rate of 20%, and an additional £1,000 being taxed at the higher rate of 40%.

  3. Gross personal pension contributions are deducted from net income to arrive at adjusted net income. 

    Adjusted net income is used to determine the amount of personal allowance available.

Illustration 2:

Eli has a trading profit of £50,000 and he paid £2,400 (net) to a registered personal pension scheme.

  • Show the tax benefits of this contribution.

    Calculate Eli’s income tax liability.

Solution:

Benefit 1:

Eli paid £2,400 (80%)
HMRC paid £600 (20%)

Benefit 2:

Basic band extension:  £34,500 + £3,000= £37,500
Higher band extension:  £150,000 + £3,000 = £153,000

Benefit 3:

Adjusted net income = £50,000 - £3,000 £47,000
Income tax liability
Total income £50,000
Personal allowance (£11,850)
Taxable income £38,150
£37,500 * 20% = £7,500
(£38,150 - £37,500) * 40% = £260
Total income tax liability £7,760

Limitations of the tax relief available

Pensions do have the taxable benefits mentioned above. 

However, there are 2 limitations under which contributions must be to qualify for the tax relief outlined. 

These are:

  1. They must be within the relevant earnings of the individual. If not, a certain amount of the contribution will be taxable.

  2. If they are within the relevant earnings, they must be also within the annual allowances of the individual. If they are not, a certain amount of the contribution will be taxable.

What are relevant earnings?

These are the greater of

  • £3,600 and

100% of:

  • Trading income (e.g) profits from a business

  • Employment income (e.g.) salary

  • Income from furnished holiday lettings (e.g.) rental income from a FHLA

For example

if an individual has trading profits of £50,000, then the greater of £3,600 and £50,000 will be chosen as relevant earnings, £50,000 will be the relevant earnings.

if an individual has trading profits of £3,000, then the greater of £3,600 and £3,000 will be chosen as relevant earnings, £3,600 will be the relevant earnings.

What is the annual allowance?

This is an allowance given to individuals every year. 

The individual can use the allowance yearly, and the amount unused is carried forward for 3 years, but only if they are a member of the pension scheme in those years.

  • Therefore, at any particular time, an individual can use their current year allowance plus 3 years’ b/f unused annual allowances on a FIFO basis. 

    The gross contributions are deducted from the annual allowances.

2015/16 £40,000
2016/17 £40,000
2017/18 £40,000
2018/19 £40,000

Illustration 3:

Sally's trading income for the year ended 05/04/2019 were £60,000.

Sally made contributions of £56,000 (gross) into a personal pension scheme during the tax year 18/19.

She has made gross pension contributions of £30,000 per annum for the last 10 years.

How much of the pension contribution qualifies for relief?

What is the income tax liability of Sally?

  • Solution

    Sally’s relevant earnings are the higher of £3,600 and £60,000:

    Therefore, Relevant earnings is £60,000.

    Therefore, the pension contribution is within 100% of relevant earnings.

    However, is the contribution within the annual allowance?

Current year annual allowance £40,000
15/16 b/f annual allowance 40,000 - 30,000 £10,000
16/17 b/f annual allowance 40,000 - 30,000 £10,000
17/18 b/f annual allowance 40,000 - 30,000 £10,000
Total allowance £70,000
Gross contribution    £56,000
Total allowance         (£70,000)
The contribution is within the annual allowance, therefore £56k qualifies for the tax relief

What happens if the gross contributions are above the relevant earnings or annual allowance available?

The additional amount is added to the total income, on top of other income, therefore it is chargeable to income tax at the highest rate that the individual pays.

This is called the annual allowance charge.

Annual allowances only start to accumulate in the first year that an individual makes a contribution.

Illustration 4:

Sally is self employed. 

Her trading income for the year ended 05/04/2019 were £60,000.

Sally made contributions of £56,000 (gross) into a personal pension scheme during the tax year 18/19.

She has made gross pension contributions of £39,000 per annum for the last 10 years.

  • How much of the pension contribution qualifies for relief?

  • How much will result in an annual allowance charge?

  • What is the income tax liability of Sally?

Solution:

Sally’s relevant earnings are the higher of £3,600 and £60,000:

  • Relevant earnings: £60,000

  • Therefore, the pension contribution is within 100% of relevant earnings.

  • However, is the contribution within the annual allowance?

Current year annual allowance £40,000
15/16 b/f annual allowance 40,000 - 39,000 £1,000
16/17 b/f annual allowance 40,000 - 39,000 £1,000
17/18 b/f annual allowance 40,000 - 39,000 £1,000
Total allowance £43,000
Gross contribution    £56,000
Total allowance         (£43,000)
Annual allowance charge  £13,000
Total income
Trading income £60,000
Annual allowance charge   £13,000
Total income £73,000

Basic Band extension:  £34,500 + £56,000 = £90,500

Income tax liability:

Total income £73,000
Less P.A. (£11,850)
Taxable income £61,150

£61,150 * 20% = £12,230

Tapered annual allowance

  • If AI (Adjusted Income) is more than £150,000 then the CURRENT year Allowance is a tapered allowance

  • It means that the normal annual allowance of £40,000 is reduced by £1 for every £2 by which a person’s adjusted income exceeds £150,000, down to a minimum tapered annual allowance of £10,000. 

    This is similar to how personal allowances are reduced, except the adjusted income, in this case, needs to be £150,000 to reduce, not £100,000.

    Therefore, a person with the adjusted income of £210,000 or more will only be entitled to an annual allowance of £10,000 (£40,000 – ((£210,000 – £150,000)/2) = £10,000). 

    Tapering applies on a tax year basis, so a taxpayer with variable income might find themselves entitled to the full £40,000 annual allowance for some years, and a tapered annual allowance in other years. 

    For example if the taxpayer only has adjusted income of £100,000 then they will be entitled to the full £40,000 but  if the taxpayer has adjusted income of £160,000 - then they will be entitled to (£160,000 - £150,000 = £10,000/2 = £5,000, A.A. £40,000 - £5,000 = £35,000 annual allowance available.

    A.I. for self employed = Net income

    A.I. for employed = Net income + Employer contributions to pension scheme + Employee contributions to pension scheme

    Remember that it is only the 2016/17, 2017/18 and 2018/19 annual allowances that you will apply this tapering to, the other allowances are always given in full .

  • If the annual allowance is not fully used in any tax year, then it is possible to carry forward any unused allowance for up to three years on a FIFO basis.

    For this exam, you will be carrying forward annual allowances from 2015/16 onwards based on the £40,000 that was applicable in that year.

    If there is any annual allowance remaining from 2018/19, after the tapering has been done to the allowance, this can also be carried forward in the normal way.

    General rule carry forward is only possible if a person is a member of a pension. scheme for a particular tax year.

    Therefore, for any year in which a person is not a member of a pension scheme the annual allowance is lost.

Illustration ANI < £150,000

Peter has made the following gross personal pension contributions:

2015/16 £32,000
2016/17 £31,000
2017/18 £19,000
2018/19 £48,000

Peter's adjusted income for the tax year 2018/19 is £140,000.

Will Peter be subject to an annual allowance charge?

Solution

No, Peter will not be subject to an annual allowance charge.

The pension contribution of £48,000 for 2018/19 has used all of Peter’s annual allowance of £40,000 for 2018/19 and 
£8,000 (48,000 – 40,000) of the unused allowance of £8,000 (40,000 – 32,000) from 2015/16. 

Unused allowances to carry forward to 2019/20: 
£9,000 (40,000 – 31,000) from 2016/17

£21,000 (40,000 – 19,000) from 2017/18.

Illustration ANI>£150,000

Chirag has made the following gross personal pension contributions:

2015/16 £32,000
2016/17 £31,000
2017/18 £19,000
2018/19 £8,000

His adjusted income for the year is £250,000. This is the first time that his AI has been above £150,000.

Will Chirag be subject to an annual allowance charge?

Solution

Yes.

Chirag’s tapered annual allowance for 2018/19 is the minimum of £10,000 because his adjusted income exceeds £210,000.

His contribution this year is only £8,000 - therefore it is within the tapered annual allowance of £10,000 and he will have £2,000 to carry forward to 2019/20.

Unused allowances to carry forward to 2019/20:
of £9,000 (40,000 – 31,000) from 2016/17,
£21,000 (40,000 – 19,000) from 2017/18
£2,000 (£10,000 – £8,000) from 2018/19.