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Earlier this year, higher earners came under attack on several fronts during the Budget Speech.  One area that was targeted was higher rate income tax relief on pension contributions.

Pension tax relief is often misunderstood, so the new (and interim) rules on this are anything but simple.  Here is our hopefully quite simple guide to higher earners and pension tax relief.

The way it was

Before the Budget, higher earners received higher rate income tax relief on their personal contributions to a pension plan.  This tax relief was applied in two parts.

Basic rate tax relief (at 20%) was added directly to the pension fund when a personal contribution was made.  In practical terms, this means that a £1,000 net contribution to a UK registered pension scheme would receive £250 of basic rate tax relief, so £1,250 would end up in the pension fund.

Higher rate taxpayers were then able to claim the difference between basic and higher rate income tax relief on their contributions.  This difference is currently 20%, so that same £1,000 net pension contribution would enable the higher rate taxpayer to claim additional tax relief of £250, making the total tax relief £500, or an £750 net contribution resulting in an investment in the pension fund of £1,250.

What changed?

The new rules announced in the Budget earlier this year will result in pension tax relief limited to 20% for people earning over £180,000 a year.  In fact, the amount of income tax relief on offer will start to reduce once you earn £150,000 a year, being tiered down to reach 20% once earnings hit £180,000.

In the meantime, and to prevent any short-term abuse of the system before the new rules come into force, some interim measures were introduced.  These are known as anti-forestalling measures.

It is important to note that these anti-forestalling measures only apply to people who are categorised as ‘high income individuals’.  To get this special label attached, you need to have ‘relevant earnings’ of £150,000 per annum in this or either of the previous two tax years.

‘Relevant earnings’ is a fairly catch-all phrase, and includes income from employment and self-employment, savings interest and dividends. You have to add back in any earnings which have been sacrificed as part of a salary sacrifice arrangement with your employer but you can subtract pension contributions up to £20,000 made by the individual (but not employer pension contributions).

I’m a ‘high income individual’ – so, what now?

Assuming that you fall into the definition described above, you become subject to a special annual allowance. This is an annual tax allowance which places restrictions on the income tax relief you can get on your pension contributions.

The special annual allowance is one of three numbers. Firstly, there is a basic allowance of £20,000.

Secondly, there is an enhanced allowance of up to £30,000 which can be applied if you have made infrequent pension contributions (less often than quarterly). This enhanced allowance is calculated as the lower of average contributions made in the three tax years in the three tax years 2006/07, 2007/08 and 2008/09 and £30,000.

Finally, you might have a protected pension input amount. This is calculated based on your regular (quarterly or more frequently) pension contributions before 22nd April 2009, the date these anti-forestalling measures came into force.

Regardless of which level of special annual allowance applies, it will apply to both your personal and employer pension contributions.

What happens if more goes into my pension?

If you and/or your employer happens to contribute more to a pension, either before the end of this tax year or during the 2010/11 tax year, it is not the end of the world. The penalty is a special annual allowance tax charge.

The special annual allowance tax charge is a tax charge made on the individual at a rate of 20% for the 2009/10 tax year. What this means in practice is that you lose your higher rate income tax on those parts of the pension contributions above your special annual allowance.

This might not feel too bad if it is personal contributions at stake. It will simply mean you claim for and pay back any higher rate income tax relief on contributions over the level of the special annual allowance. Where it is employer pension contributions, you might feel a bit unhappy about having to pay a 20% tax charge on money you never actually received in your pocket.

What next?

This is only a basic guide and you should seek professional independent financial advice if there is a chance you have been caught up in these new or interim rules.

Martin Bamford is site editor of BrilliantWithMoney and a Chartered Financial Planner at Informed Choice. You can follow him on Twitter @martinbamford.