We’ve all heard it before: “make sure you’re saving enough into your pension for retirement”. And in many cases, it’s the prudent thing to do. However for high-earners, this is one of those rare cases where it’s possible to have too much of a good thing.

Once your total income exceeds £260,000 (which is all income including rental income), the government starts restricting the amount of tax relief you can get on pension contributions. It’s a common pitfall for high-earners who may not realise that their generous pension contributions could be their biggest financial misstep.

This short article is designed to show you some of the overlooked consequences of oversaving into your pension (including tax penalties!), help you to identify if you are affected, as well as signpost other opportunities to make your money work harder in the long run.

Pensions – the basics

Pensions are typically a very tax efficient way to save for your future:

• You receive income tax relief on your personal contributions at your marginal tax rate
• Your investments can grow free of income and capital gains tax
• When you withdraw from your pension, you can take up to 25% tax free (the remainder is subject to income tax at your marginal rate)
• Pensions are outside of your taxable estate, which means they are typically not subject to a 40% inheritance tax charge on death.

What are the limits?

• For high-earners, the contributions you can make are typically limited each tax year by your annual allowance
• This starts at £60,000 but crucially reduces down for people earning over £260,000. This is called the Tapered Annual Allowance.

Who is affected by the Tapered Annual Allowance?

The Tapered Annual Allowance usually begins to apply once you earn over £260,000 per year. If you earn less than £260,000 per year, you are likely to be entitled to the full annual allowance of up to £60,000 and you may also be able to ‘carry forward’ any of the previous three years' annual allowances which you didn't fully use.

If you earn over £260,000, then your annual allowance will start to taper off and be reduced depending on how much income above £260,000 you earn. This calculation can be a little complex, however broadly speaking your allowance reduces by £1 for every £2 of income above this figure. As an example, if you earn £280,000 (£20,000 more than £260,000), you will lose £10,000 of your annual allowance i.e. it will be £50,000.

This reduction is capped once you reach a total income of £360,000 - this means your annual allowance can only be reduced down to £10,000. Whilst this may seem low, the more positive news is this has recently been increased from just £4,000 in the 2022/23 tax year.

Unexpected tax bills?

If you overcontribute to your pensions, you will be required to pay back tax relief on the excess via your annual self-assessment tax return. This can create an unexpected issue for those who have accidentally over-contributed to their pension, where they have a tax bill due but are unable to access the funds as they are locked in their pension.

Getting the calculation right if you are impacted by the Tapered Annual Allowance can be tricky, especially if it requires carry forward calculations from your unused allowances in the last 3 years (which may also have been impacted by the Tapered Annual Allowance using different rates).

What should you do if you have a Tapered Annual Allowance?

Employed

You should check what level your pension contributions are and whether you're going to exceed your annual allowance. At this point, take stock of the contributions and consider your options.

Many employers who are used to this type of situation can be flexible and cap your pension contributions at your annual allowance or even just stop them all together, giving you other forms of remuneration, instead of the lost pension remuneration.

Business owner / self employed

Make sure you manage your pension contributions in accordance with your annual allowance - you should have full control over this.

Where else can you save?

This is often the question I get asked the most by people with income over the Tapered Annual Allowance limits. And the answer? Well, it depends. And it’s impossible to say without understanding the wider picture.

Consider this example: two people are earning £400,000 each year. The first, Sophie, spends £50,000 a year on school fees. The second, Rachel, has no children, and is saving for the longer term. Both Sophie and Rachel’s goals and time horizons for their investments will be very different and so their financial planning strategy will need to be too.

What's right for one person may not be right for the other. We've all got different values and goals and good financial planning is making sure the decisions you make with your money are:

1. Geared towards helping you achieve what is important to you; and
2. Considered in context of the time frames relevant to your goals.

Some of the tools at your disposal for long-term investing include:

1. Carry forward unused pension allowances: you can carry forward the last three years of unused allowances. This is a great way to get more money in your pension for the future, whilst saving yourself tax today. Unused allowances fall away after three years - so it’s a case of use it or lose it.

2. ISAs: There’s a £20,000 allowance per person, and family allowances available (including Junior ISAs) each tax year. This is a great way to invest for the longer term as all income and capital gains in an ISA are tax-free.

3. GIAs: General Investment Accounts (GIAs) are similar to ISAs, but with no limit on investment amounts, and income and gains are subject to tax. Each individual has a £1,000 dividend allowance and an annual capital gains tax exemption of £6,000 in the 2023/24 tax year (although these figures are set to change in 2024/25 to £500 and £3,000 respectively) so you can save tax-effectively in this environment. Using these allowances can help generate a well diversified asset base for the future.

4. Tax-efficient investments and investment bonds: The UK government offers various investment schemes to encourage private investment in certain sectors, like smaller companies. This can come with 30%-50% income tax relief, depending on the specific investment type.

These schemes can be useful alternative tax-efficient investment wrappers for higher earners, if you have the right risk appetite. Plus, dividends may be tax free and capital gains tax free, depending on the scheme.

Investing in smaller companies is high risk however and not for everyone. When considering these types of investments it's crucial to consider your financial plan and tolerance for risk, as well as your likely time frame for needing access to these investments.

Investment bonds are also an option for higher earners that have used up the usual pension, ISA and GIA investment routes. Investment bonds can be highly tax-efficient and can add a lot of flexibility to your financial plan. These are highly complex products, however, and you should seek expert advice before considering investing in this way.

If you earn over £260,000 and you're not looking at your pension provision in detail, get in touch for a conversation about how we can help.

We can also help you explore a number of other ways to build a tax-efficient and flexible portfolio, tailored around you and your family's future goals, whatever they may be.

Disclaimer:

This blog post is a marketing communication for information purposes only and is not intended as an offer or solicitation to buy or sell any particular financial product. The facts and figures mentioned in this article are relevant for the 2023/24 tax year and may not be correct for previous or future periods. Personal opinions may change and in producing this article we have not taken into consideration any individual circumstances, therefore it should not be seen as advice or a personal recommendation.

Any references to past performance should not be taken as a reliable indication of future returns. The value of an investment, and any income from it, can fall or rise. Fees and commissions may have not been expressly indicated, and you should take into account the effects that these have on the performance of a financial portfolio.

Nova Wealth is a trading name for Octopus Wealth Limited which is authorised and regulated by the Financial Conduct Authority (FRN: 778951).