Pension savers caught out by annual and lifetime allowances

Significant numbers of savers are having to hand over sizeable charges to the taxman because they have breached their pension allowances

Saving the biggest pension possible is a sensible move for all of us. After all, that money has to last us throughout our twilight years ‒ simply taking up a new job to supplement a mediocre pension might not even be possible. 

Relying on the State Pension is a similarly risky move, given it’s already one of the least generous in the developed world.

So it’s welcome that the auto-enrolment scheme ‒ where employees are automatically enrolled into a pension by their employer, who then contributes to the pension as well ‒ has been such an enormous success, with millions of savers now paying into a pension who otherwise wouldn’t be.

Unfortunately, it seems that the rules around the annual and lifetime pension allowances are catching increasing numbers of people out, landing them significant charges.

Hitting the allowance

First off it’s worth a reminder of exactly how these allowances work.

The annual allowance, as the name suggests, is the maximum amount that can be saved within a person’s pension pots during a tax year before they then have to pay tax on those contributions. It currently stands at £40,000.

And then the lifetime allowance covers the maximum amount that a saver can place into their pension over their lifetime before they start paying tax on it. The annual allowance currently stands at £1,073,100.

Coughing up for passing the allowance

New figures released this week by HM Revenue & Customs show a marked increase in the amounts that savers have started putting into our pensions over the last few years.

For example, in the 2019-20 tax year a whopping £31.3 billion was paid into personal pensions, up from the £27.9 billion paid in the previous year. In addition, the total value of contributions to personal pensions has grown by an average of 11% per year over the last three years.

But those larger contributions are seeing more people falling foul of the allowance limits. That same HMRC data found that more than 21,000 annual allowance charges were reported, at a total value of £253 million.

That’s an increase of 20% on the year before.

It’s a similar story with the lifetime allowance, where there was a 21% increase in the value of charges reported to £342 million.

So why are increasing numbers of savers falling foul of these rules?

Stripping back allowances

The first contributing factor here is the fact that these allowances have been repeatedly cut back in recent years.

A little over a decade ago, the lifetime allowance stood at £1.75m while the annual allowance came to £245,000. However, time and again, Chancellors have seen these allowances as a simple way to save a few quid, trimming them back to their current levels.

Inevitably this has resulted in far more people falling foul of them and finding they are required to hand over sizeable charges to the Treasury.

Unnecessarily complex

Another big factor here is that the system is incredibly complex. That’s because there are not only annual and lifetime allowances to bear in mind, but money purchase and tapered allowances too.

The money purchase annual allowance (MPAA) applies to people who have started dipping into their pension pots through the pension freedoms, but may still want to contribute to that pot.

It’s something that has happened a fair bit over the last year and a half, with savers opting to release some of the money from their pots to support them during the pandemic, without necessarily wanting to completely retire and so they have continued paying into their pension.

If you trigger the MPAA, the annual allowance drops from £40,000 down to just £4,000.

Meanwhile, the tapered annual allowance is effectively a stripping back of the normal annual allowance for high earners, depending on precisely how much they are bringing in. Right now it applies for those with a ‘threshold income’ of over £200,000 and an ‘adjusted income’ of over £240,000.

As Tom Selby, head of retirement policy at AJ Bell put it, this is a perfect example of the “horrific complexity in the retirement system” that we currently put up with.

Ultimately, the system doesn’t have to be this complex. It’s perfectly possible to draw up broad parameters for how much people can contribute to their pensions each year, and over their lifetime, before they have to start paying tax without it ending up in the current befuddling maze of thresholds and restrictions.

Unfortunately, the taxman actively benefits from it being this complicated, because it means that people find it harder to plan and therefore fall foul of the rules.

I think Jon Greer, head of retirement policy at Quilter, had it spot on when he said: “While auto-enrolment has been a very successful step in the right direction, it’s important that the highly complex rules around the annual allowance don’t hamper the good work the policy has done.

"These rules require an intricate knowledge of the UK’s pension landscape to understand and therefore time and time again catch people out.”

Requiring savers to have that level of knowledge in order to avoid these charges is ridiculous and counterproductive.