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Pension Annual Allowance: Questions answered | accountingweb

Pension annual allowance: How it works


With 31 January fast approaching, Andy Keates answers questions on the pensions Annual Allowance Charge and solves the mystery of scheme pays.

17th Jan 2023
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As we get perilously close to the 31 January deadline, the issue of the pensions Annual Allowance Charge (AAC) is focusing the minds of many taxpayers and their advisers. Time for a “quick and dirty” guide to how the AAC works, and the mystery that is “scheme pays”.

Annual allowance (AA) is the maximum amount of tax-relieved “inputs” that an individual can make into pensions during a tax year. I’ve used the – perhaps unfamiliar – term inputs because it is the word the legislation uses to cover two very different things:

  • For a money purchase (defined contribution (DC)) arrangement, it is the gross amount of contributions made by either the member or an employer into the scheme.
  • For a final salary (defined benefits (DB)) arrangement, a member’s pension rights are not based on contributions. The input is the increase in the hypothetical capital sum (or pension pot) that would be required to pay the member’s currently accrued pension entitlement, compared to the value of that notional pot in the previous year.

The exact calculation is given in s234 Finance Act 2004, and will vary according to the circumstances of the member and the scheme’s rules. Thankfully, calculating the inputs and informing every member is part of the scheme administrator’s job. 

In virtually all cases, length of qualifying service is a significant factor, so it’s worth remembering that an individual’s pension rights will have grown in value year on year, even if their salary has remained unchanged.

The AA applies to individuals, not to specific pension pots, so the taxpayer needs to aggregate the inputs from all the schemes of which they have been a member during the year. However, if an individual has taken full benefits under a pension scheme as a result of severe ill health (or has died) during the year, that scheme will not be counted towards the AA.

The current level of the AA is £40,000 (reduced for very high incomes: for anyone earning in excess of £312,000 the AA is £4,000).

What if the AA is exceeded?

It’s not necessarily a problem if an individual exceeds the AA in a particular year. Any annual allowance for the three preceding years, which was not used up at the time, can be carried forward (on a first-in-first-out basis) to absorb any excess in the current year. 

Unused AA can only be carried forward from a year in which the individual was a member of one or more pension schemes. However, if he was a member of a scheme but made no inputs into it, the full AA for the year is available for carry forward.

If – after taking account of any unused AA – there is an excess of inputs over the Annual Allowance, the member is subject to a tax charge (the AAC). 

The charge

The rationale is that tax relief has automatically been received: 

  • directly on any contributions made by the member up to 100% of his earnings
  • indirectly on employer contributions or defined benefit growth, because they are excluded from the calculation of employment income.

The AAC is therefore structured to recoup the income tax relief that the individual has received. The excess is added on as if it were the top slice of the individual’s taxable income, and charged at whatever marginal rates would apply (basic, higher or additional rate for England and Wales or starter, basic, intermediate, higher or top rate for Scotland).

Who pays it?

The default position is that the AAC is the responsibility of the individual, and needs to be reported on the tax return, included in the self assessment and paid by the usual 31 January date.

There are, however, situations where the scheme administrator can be called on to pay some or all of the AAC for a member. This is known as “scheme pays”. 


For scheme pays to apply to any pension scheme, two conditions need to be met:

  1. The tax due under the AAC exceeds £2,000, and
  2. The input from that scheme (in isolation) would exceed the annual allowance.

Where the conditions are met, the member may make an election at any time between the end of the tax year and the 31 July following the end of the next tax year. For 2021/22, the deadline is 31 July 2023.

If the member’s pension rights have been transferred to a different scheme before an election is made, the member must make the election to the administrator of the receiving scheme.

On a valid election, the administrator of a scheme becomes jointly and severally liable to pay so much of the AAC as is represented by the member’s inputs to that scheme.

When the scheme pays all or part of a member’s AAC, a consequential adjustment must be made to the member’s rights under the scheme “on a basis that is just and reasonable having regard to normal actuarial practice”. For DC schemes, the tax is simply deducted from the member’s pension pot. For DB schemes, a more complex calculation will be due, with potentially significant impact on the eventual level of either pension, lump sum or both.

Because of this statutory obligation to make consequential adjustments (reductions) to the member’s rights under the scheme, scheme pays cannot be invoked where this would affect entitlement to a guaranteed minimum pension.

Multiple schemes

The legislation for condition 2 – at FA2004 s237B(1)(b) – is quite stringent. A scheme administrator can only be required to settle an AAC when (and even then only to the extent that) the inputs for that scheme have unequivocally resulted in an excess. This can lead to difficulty in the case of individuals whose inputs are spread among numerous schemes.


Alex is a member of three schemes, and his inputs for 2021/22 were as follows (no carry-forward is available):

Scheme A: £39,000

Scheme B: £41,000

Scheme C: £40,000

His AAC will be based upon an excess of £80,000. He cannot elect for Scheme Pays in respect of either Scheme A or Scheme C, since in neither instance – taken in isolation – would his inputs exceed the AA.

He can elect for Scheme Pays in respect of Scheme B, but only in respect of an excess of £1,000. For the remaining £79,000 of his excess, only he is liable.

Voluntary scheme pays

Depending on its own specific rules, a pension scheme may allow for the settlement of a member’s AAC out of scheme funds even where this is not required. In doing so, the scheme does not become jointly liable with the member, who will remain personally liable to any late payment penalties if the liability is paid after the normal 31 January tax deadline.

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