Are There Any Pension Contribution Limits?
We have seen quite a few changes to the UK pension system with the introduction of reform measures. First was the establishment of auto-enrolment, which the government began rolling out in 2012. Then there were new pension freedoms granted to savers looking to access their pension pots from the age of 55. And of course, the new state pension kicked in from April 2016. It turns out that all of the reforms are not necessarily good. A case in point is in the reduction of pension contribution limits in recent years.
From 2014, the amount of money pension savers could contribute was reduced across the board. Reductions apply to everything from annual salary to both annual and lifetime allowances. The purpose of this guide is to bring you up to date with where we stand at the current time. Please bear in mind that the government may once again change limits in the future. What is true today may no longer be true a few years from now.
Limits and Taxation
Before discussing the actual limits in question, it is important to first establish one important fact: government regulations do not prohibit you from putting any amount of money away in a pension. You can put away as much as you want at any point during your career. After all, it is your money. What we are referring to when we talk about pension contribution limits is the idea of taxation and how it applies to the money you do save.
As long as pension savers do not need the government limits, any money saved in a pension during a given calendar year is free from income tax. For purposes of example, let us assume that you earn £30,000 annually and you save 2% by way of your workplace pension. That 2% equates to roughly £600 per year. You do not pay any income tax on that money because it is not included in your annual taxable income. Conversely, any amount saved above and beyond the limits we will discuss in a moment is subject to income tax. It is part of your annual taxable income reported to HMRC every year.
Current Pension Contribution Limits
There are currently three ways pension contribution limits are applied to UK workers. The first is related to your annual earnings, the second is related to the annual allowance, and the third is related to the lifetime allowance. We will look at all three.
The annual salary limit is the one most UK workers are affected by. It works as follows: you are only allowed to contribute up to 100% of your annual salary and still be eligible for tax relief. Let's use the same £30,000 salary we mentioned earlier. Under such a scenario, you could put £30,000 into one or more pensions and still be free of income tax on the money as long your total pension contributions do not exceed £30,000.
What you must understand is that total pension contributions under this scenario include three things:
- The money you contribute
- The money your employer contributes
- The money contributed by way of tax relief.
The combination of all three cannot exceed your annual income if you want to remain clear of income tax. If you exceed that level, income tax is applied to the excess only, not the base amount. As a side note, if tax charges exceed £2,000, these can be paid out of your pension so you do not have to pay out-of-pocket.
Moving on to the annual allowance, it has now been reduced to £40,000. This would not apply to someone making less than the allowance, only to those making more. Let us assume that you were making £60,000 annually and you contributed to both a workplace pension and a SIPP. Your total contributions in any given tax year cannot exceed £40,000 without income tax applying to the excess. It does not matter how your contributions are spread out across both of your pensions.; your annual allowance is £40,000 in total.
Lastly, pension contribution limits were reduced for lifetime contributions. What's different about the lifetime allowance is that it is not related to contributions per se, but to the total value of your pension savings. Here's how it works: if the total value of all of your pensions exceeds £1.25 million, any money you contribute to them in the future will be subject to income tax.
Special Considerations for Savers
There are some special considerations where pension contribution limits are concerned. The first consideration relates to annual allowances. The current annual allowance of £40,000 applies unless you do one of three things:
- Purchase an Annuity – Using funds from your pension to purchase an annuity, either for immediate payment or deferred for the future, is an action that constitutes accessing your pension for retirement. You could continue contributing tax-free to the remaining portion of your pension funds but your annual allowance wold be reduced to £10,000.
- Take Cash – If you take cash out of your pension pot as a lump sum, the same rules apply. Your annual pension contribution limits are reduced to £10,000.
- Enter a Drawdown Contract – Some drawdown contracts, depending on how they are structured, also trigger the lower pension contribution limits on an annual basis. You would have to discuss this with your pension operator to know whether or not the lower limits would apply in your case.
A second consideration is whether the tax benefits of remaining below the annual or lifetime limits is beneficial to you or not. Let's assume you are one of those high wage earners that exceeds six figures annually. Does it really make sense for you to put any money into a pension at all if your only goal for doing so is to establish tax-free savings for the future? Perhaps not. The reality is that pension savings are not tax-free forever. What you save in income tax on the front end you will pay when you begin withdrawing money on the back end.
You may be in a better tax position by forgoing a pension altogether and putting your money into other kinds of investments. More lucrative opportunities may provide a stronger return that offsets both income tax and capital gains while still leaving you with more money at the end of your career.
Again, all this has to be discussed with a financial advisor familiar with pension contribution limits and taxation. Trying to make such decisions without sound advice is asking for trouble.
Keeping Track of Your Allowances
If your advisor recommends keeping track of your annual and lifetime allowances for tax purposes, it is a fairly easy thing to do. Your lifetime allowance can be monitored simply by paying attention to the monthly statements your pension operators send you. Those statements will tell you the value of your pension pots at any given time. As for the annual allowance, HMRC offers a free tool that you can use to check where you stand.
Accessing this tool is a matter of logging on to the HMRC website and navigating to the Pensions Schemes section. Alternatively, you could simply use your favourite search engine to track down 'HMRC annual allowance checking tool'. In order to use the tool, you will need to know what kind of pension you are contributing to and approximately how much you have already contributed this year. The tool then matches your contributions with likely employer contributions and tax relief to come up with a figure.
Pension contribution limits are part of the pension saving game. You may not have to worry about them if you don't earn or save enough to come close to reaching them. Still, it's good to know what they are. Having this knowledge puts you in a good position should you ever reach a point in your life where you are making and contributing enough to trigger income taxes on excess contributions.
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