How not to lose your personal allowance

Paul Leatherbarrow, Liverpool

Those with an ‘adjusted net income’ in excess of £100,000 saw their basic personal allowance reduced or removed entirely from April 2010.There will be a loss of £1 in personal allowance for every £2 of income earned over £100,000. Which means the personal allowance is lost when earnings equal £112,950 (the personal allowance for 2010/2011 is £6,475) – giving an effective 60% tax bill on this band of income. Looked at another way this is a 20% increase in tax on a band of £12,950. This amounts to certain people having to pay an extra tax of £2,590 (over £200 extra tax every month?)

This extra tax bill can be avoided by planning now – don’t leave it until the end of the tax year Adjusted net income can essentially be defined as taxable income reduced by specified deductions. Examples of deductions are trading losses and payments made gross to pension schemes as well as grossed-up gift aid and pension contributions which have

received tax relief at source. This means that provided an individual’s adjusted net income is below or equal to the £100,000 limit, they will continue to be entitled to the full amount of the basic personal allowance.

This is especially relevant for those who wish to use salary exchange, as to meet HM Revenue & Customs (HMRC) rules, it’s vital that any salary exchange is agreed with the employee before the salary or bonus is received.

How to keep adjusted net income below £100,000

The personal allowance in 2010/2011 is £6,475 and the basic rate tax band is £37,400. Let’s imagine you are earning £112,000, and in April 2010 you started a new pension plan with a contribution of £1,000 a month (£12,000 during the tax year).

If you have earnings of £112,000, and no other income, in 2010/2011 you will not only be liable to 40% tax on the top £12,000 ‘slice’ of your salary, but you will also lose £6,000 of your personal allowance (£1 for every £2 above £100,000). This amount of £6,000 will be liable to 40% tax, meaning the overall tax liability on your top £12,000 slice of salary is effectively £7,200, or 60%. Individual pension contribution if you make a personal pension contribution of £12,000 gross, your adjusted net income will be reduced to £100,000. Not only will this reduce your higher rate tax liability, but it also means that you will retain your full personal allowance. Your effective tax relief on

the £12,000 pension contribution is £7,200 (60%).

Salary exchange

Had you taken this a step further and been involved with a salary exchange, the benefit would have been even greater due to national insurance contribution (NIC) savings. You could have simply arranged a salary exchange of £12,000. However, a salary

exchange of a little more at £12,204 to bring your salary down to £99,796 would mean your net income would have remained the same as it would have been if you had paid the pension personally, at £65,191. This reduction in salary would have saved the employer £12,204. The employer would also have saved NIC of £1,562 meaning the

employer could easily have afforded a contribution of £13,766. Your effective tax relief on the £13,766 pension contribution (for a reduction in take home pay of £4,800) would have been 65%.

Incomes over £130,000

Clearly the anti-forestalling rules and the rules that will apply from April 2011 onwards need to be considered when looking at pension contributions and salary exchange but large contributions shouldn’t be dismissed for individuals who are on higher incomes.

For instance if you have adjusted net income of £140,000 in 2010/2011 and therefore have lost the whole of your personal allowance. Providing you did not have relevant income of more than £130,000 last year or the previous one you are not caught under the anti-forestalling rules. This is because your relevant income for 2010/2011 would be reduced by a maximum of £20,000 due to the personal contribution of £40,000 and would mean relevant income of less than £130,000 in 2010/2011. A personal pension contribution of £40,000 would mean retaining the full allowance and an effective tax relief rate of 46%.

What is Anti-forestalling?

Important legislation has been introduced to prevent those potentially affected from seeking to forestall these changes by increasing their pension savings in excess of the normal pattern, prior to these changes taking effect. This means that members will not be able to front-load their pension contributions prior to these provisions coming into force.

The anti-forestalling provisions will have effect for contributions paid under defined contribution arrangements and increases in the rights of individual members under defined benefit pension schemes on or after 22 April 2009.

Currently, the maximum amount which an individual can contribute to a registered pension scheme is calculated by reference to an annual allowance set by HMRC. 2010/2011 it is £255,000. Any pension contributions made in excess of this limit will trigger a tax charge. However, the Finance Act 2009 introduced a new and additional special annual allowance (set at £20,000) and associated tax charge. Basically, if an individual's non-regular pension savings in a tax year exceed the special annual allowance, then the individual will have to pay a special annual allowance charge on the excess of the difference between the top rate of tax and basic rate (20% for 2009/10). The tax charge therefore has the effect of restricting tax relief on additional pension savings to the basic rate of tax (i.e. 20%) and will be collected through the self assessment tax return. The vast majority of pension savers will not be affected by the new allowance and tax charge which will not apply to:

anyone with income of less than £150,000 for the tax year, and for both of the preceding two tax years (‘relevant tax years’); and

people with income of £150,000 or more in any of the relevant tax years, and who continue as normal with their existing pattern of regular pension savings and who do not make any additional pension savings.

Furthermore, anyone who does increase their pension savings on or after 22 April 2009 over and above their normal pattern of regular pension savings will be affected only if their total pension savings in that year are over £20,000. The tax charge will not apply to any normal, regular ongoing pension savings that were in place before 22 April 2009, whatever their value. It applies only to additional savings over and above this.

Refunds

Finally, it might be the case that some individuals may inadvertently exceed the new special allowance, if, for example, they earn more than £150,000 a year and had been making non-regular contributions like AVCs which would take them above the special annual allowance. If this is the case, then it will be possible for the scheme administrator to refund any such contributions as a contribution refund lump sum (subject to a tax charge of 40% of the value of the payment on the scheme administrator).

If you

Summary

• Taxable income increases by £1 for every £2 of additional earnings up to £12,950 – effectively 20% extra tax – potential increase in tax of over £200 a month

• Pension contributions reduce adjusted net income

• Effective tax relief of 60% on pensions for those with income over £100,000 and up to £112,950

• Effective tax relief of as high as 65% if contributing through salary exchange

• Savings are not just for those on incomes between £100,000 and £112,950

• Don’t dismiss salary exchange or contributions over £20,000 if your income is over £130,000

How not to lose your personal allowance

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