What is the annual allowance?

The annual allowance provides for the annual increase in an individual's rights under all registered pension schemes to be calculated. This is then compared with the annual allowance and any excess charged to income tax at 40%.

For 2006/07 the annual allowance will be set at £215,000. Figures for subsequent years are not yet set but it will rise to at least £255,000 by 2010. The level will then be reviewed every five years.

The annual increase in rights is calculated differently according to the type of scheme. For a money purchase scheme the increase will be the total of contributions made in the year by the individual and any employer. For defined benefit schemes the increase calculation is complex. Broadly it will be the difference between the value of the rights at the beginning and end of the year with the opening values uprated by inflation.

In order to lessen the effect of the annual allowance when someone is close to retirement, it will not be applied in any year in which the benefit is taken in full.

Example of employee and employer contributions

Jo is a shareholder/director in his family company. He draws an annual salary of £5,000 and takes significant dividends out of the company. He has a personal pension.

Under the new regime, in 2006/07 Jo would be able to pay an annual contribution of £5,000 (gross)(with tax relief) into his fund. More could be paid but there would be no tax relief for Jo.

The company could make unlimited contributions and obtain corporation tax relief but to the extent they exceed £210,000 (ie £215,000 annual allowance less the £5,000 Jo has paid) Jo will suffer a 40% tax charge on the excess.

However, it is clear that the company will be able to fund very significant contributions without the need for any link to Jo's salary and without creating a tax charge on Jo.