How to avoid a surprising tax bill on your pension contributions and keep your retirement funds thriving

Pension contributions can be a tax-efficient way to invest your income while building a secure and stable financial future.

However, the amount you can contribute tax-efficiently each year is capped by the Annual Allowance, set at £60,000 or 100% of your earnings, whichever is lower, for the 2024/25 tax year. This includes your own contributions, those from a third party such as your employer, and tax relief.

If your contributions exceed the Annual Allowance, you could face a tax charge. Additionally, if your income exceeds specific thresholds or you withdraw from your pension while continuing to contribute, your Annual Allowance may be reduced, potentially triggering an unexpected tax bill.

Fortunately, there are strategies to help you avoid these charges and keep your pension contributions tax-efficient.

Read on to discover how to optimise your pension contributions and keep your retirement funds thriving.

If you exceed your Annual Allowance, you may face a tax charge

If you exceed your Annual Allowance, the excess will normally be added to your income and taxed at your marginal rate.

Typically, you declare the charge by filing a self-assessment Income Tax return.

Alternatively, you may be able to have the tax charge deducted directly from your pension savings under a process known as "Scheme Pays". To use Scheme Pays, you must make a formal request to your pension provider.

You may be able to avoid exceeding your Annual Allowance by using the carry forward rule. This allows you to use any unused allowance from the previous three tax years to reduce the excess, provided you were a member of a registered pension scheme during the relevant time period.

If you earn over a certain threshold, your Annual Allowance may be lower

If your income exceeds certain thresholds, the amount you can contribute to your pension tax-efficiently may be reduced under the “Tapered Annual Allowance”.

The Tapered Annual Allowance is designed to limit the amount of tax relief available to you if you’re a high earner by gradually reducing your Annual Allowance to as low as £10,000. This reduced allowance can vary from year to year, depending on your income.

You are affected by the Tapered Annual Allowance if your income exceeds both of the following:

• £200,000 after deducting personal pension contributions – your “threshold income”.

• £260,000 including both your own and your employer’s pension contributions – your “adjusted income”.

For every £2 of adjusted income above £260,000, your annual allowance is reduced by £1, until it reaches a minimum of £10,000 for those earning £360,000 or more.

Calculating your threshold and adjusted income can be complex. A financial planner can help you understand how the taper affects your pension contributions and ensure you’re making the most of your allowances.

If you trigger the Money Purchase Annual Allowance, the amount you can efficiently contribute to your pension may be reduced

The Money Purchase Annual Allowance (MPAA) reduces the value of tax-efficient pension contributions you can make each year.

You will trigger the MPAA if you withdraw lump sums or income above your tax-free lump sum (25% of your pension value, up to £268,275) from a defined contribution (DC) pension pot while continuing to make contributions.

You will also trigger the MPAA if you buy an investment-linked or flexible annuity where your income could decrease.

Once triggered, the MPAA usually limits your annual contributions to DC pensions to £10,000, considerably lower than the standard Annual Allowance.

The MPAA applies only to DC pension contributions and does not affect contributions to defined benefit (DB) pension schemes.

Moreover, the MPAA is typically not triggered if you take a tax-free cash lump sum and use it to purchase a lifetime annuity that guarantees increasing or level income for life. Nor is it triggered if you take a tax-free cash lump sum and place your pension pot into flexi-access drawdown without withdrawing any income.

Special rules exist for cashing in small pension pots valued at less than £10,000. To avoid triggering the MPAA, ensure your withdrawals are treated under the small pot lump sum rules by checking with your pension provider. Otherwise, you may inadvertently activate the MPAA.

There are alternative ways you can invest your excess earnings to keep you below the Annual Allowance

If you are nearing the Annual Allowance or are concerned about triggering either the Tapered Annual Allowance or MPAA, you might consider the following alternative ways to ensure you stay below the threshold.

Tax-efficient investment and savings options

One of the main advantages of pension contributions is their tax efficiency. To maintain this benefit, it can be valuable to explore alternative tax-efficient options.

For instance, you could maximise your ISA contributions as ISAs provide tax-free returns on your savings and investments. You can contribute up to £20,000 into ISAs for the 2024/25 tax year.

Additionally, investing in a Junior ISA (JISA) for your child or grandchild can help secure their financial future while optimising your own tax efficiency. You can invest up to £9,000 into a JISA for the 2024/25 tax year and it doesn’t affect your personal ISA allowance.

You could also explore investing in Venture Capital Trusts (VCTs), which offer considerable growth potential as well as tax relief. However, VCTs come with significant risks, so it’s a good idea to speak with a financial planner before choosing this option.

You can read more about VCTs in our previous article on the topic.

Contributions to your child or partner’s pension

If you are nearing your Annual Allowance but your partner is not, you may be able to make contributions to their pension and enjoy the same reliefs and benefits as if you were contributing to your own. These count towards your partner’s Annual Allowance, and will benefit from tax relief at their marginal rate of Income Tax.

Alternatively, you could consider starting a pension for your child or grandchild. You can contribute up to £2,880 a year to a child’s pension (assuming the child has no earnings) and your contributions will benefit from 25% tax relief. This pension will then have the opportunity to grow throughout the child’s life, too.

In this way, you can maximise your efficiency while also helping out a loved one.

Salary sacrifice

If your salary is close to the threshold that triggers the Tapered Annual Allowance, you could explore salary sacrifice options.

Salary sacrifice can bring your take-home income down slightly for an additional benefit, meaning your effective earnings remain the same but your taxable income is reduced.

Options could include health insurance, childcare, gym memberships, and more. Speak to your employer about what options could be made available to ensure your Annual Allowance remains at the standard threshold.

Stock market investments

Investing in the stock market typically gives your extra income a better chance of keeping pace with inflation over long time horizons compared to holding it in cash savings.

So, if you are nearing your Annual Allowance and have extra income that you want to deliver long-term growth, investing in the market could be a good option.

Get in touch

A financial planner can help you ensure your pension contributions remain efficient and can explore alternative investments with you if you are nearing your Annual Allowance or close to triggering the Tapered Annual Allowance or MPAA.

To speak to a financial planner, get in touch.

Email info@mlpwealth.co.uk 020 8296 1799.

Please note

This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.

This article is for information only. Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.

Workplace pensions are regulated by The Pension Regulator.

A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits.

A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future results.

Venture Capital Trusts (VCT) are higher-risk investments. They are typically suitable for UK-resident taxpayers who are able to tolerate increased levels of risk and are looking to invest for five years or more. Historical or current yields should not be considered a reliable indicator of future returns as they cannot be guaranteed.