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Pension contributions can be a valuable tool in an individual's tax planning

Author Image The Technical Team
10 minutes read
Last updated on 6th Apr 2018

Overview

As well as the usual benefits of providing for a person's retirement, pension contributions can also be a valuable tool in an individual's tax planning. Pensions can be used to mitigate child benefit and personal allowance tax traps as well as mitigate tax on bond and CGT gains

Key points

  • Tax relief is available at an individual's highest marginal rate on contributions up to 100% of Relevant Earnings (or £3,600 if higher).
  • As well as the usual benefits of providing for a person's retirement, pension contributions can also be a valuable tool in an individual's tax planning.
  • Pensions can be used to mitigate Child benefit and personal allowance tax traps as well as mitigate tax on bond and CGT gains.
  • Personal allowance tax trap is a result of the personal allowance being reduced for income above the income limit of £100,000 - pension contributions can be used to manage income levels.
  • Chargeable gains on bonds and capital gains are charged by reference to income tax thresholds - pension contributions can be used to manage income tax thresholds. 

Planning and pension contributions

As well as the usual benefits of providing for a person's retirement, pension contributions can also be a valuable tool in an individual's tax planning.

This article deals with how to use pension contributions to help with tax planning on a UK (non-Scottish) basis. Scottish taxpayers will pay the Scottish rate of income tax (SRIT) on non-savings and non-dividend (NSND) income. NSND income includes employment income, profits from self-employment (including sole trades and partnerships), rental profits, and pension income (including the state pension).

Other tax and deductions such as Corporation Tax, dividends, savings income and National Insurance Contributions etc. will remain based on UK rules. For the 2018/2019 the rates and bands of tax relief now have significant differences to the UK rules. This could mean the amount of income tax relief which can be claimed on pension contributions by Scottish and UK tax payers may not be the same. Our Tax Relief Modeller can assist with calculations under both UK and SRIT tax regimes. For more info on SRIT and how this works in practice, please visit our facts page.

Also see our article Reduce the impact of the high income child benefit charge.

In each situation the key facts and planning principles will be explained and then case studies will illustrate the point. In all scenarios National Insurance is ignored. Relief at source contributions are assumed, however, the same tax outcome would apply equally to relief under the net pay method.

Case studies use UK rates and allowances for 2018/19.

Maximising Tax Relief

The facts

Tax relief is available at an individual's highest marginal rate on contributions up to 100% of Relevant Earnings (or £3,600 if higher).

Relevant earnings are broadly earned income; they exclude items such as pensions income, most rental income and dividends.

Under schemes operating via relief at source (RAS) the relief is obtained in one or two stages dependant on your tax rate.

Basic rate tax relief is given automatically, the pension provider reclaims this from HMRC e.g. The member asks for an £10,000 gross contribution but only pays the net amount - £8,000 and the provider reclaims the £2,000.

Higher and additional rate taxpayers get relief through their self-assessment returns or in 'one-off claims'.
 
Higher rates of relief are achieved as the individual's basic and higher rate bands are increased in tandem by the amount of the grossed up contribution. The effect of this is income moves from the 40% tax bracket into 20% and 45% into 40%.

This means that full marginal rate relief is only available where there are sufficient earnings in the marginal band 

Contribution

£8,000 net £10,000 gross

Example

A

B

Taxable Income

£160,000

£155,000

Tax Relief

£2,000 RAS plus £2,500 reduction in tax bill

£2,000 RAS plus £2,250 reduction in tax bill

Effective Rate of Relief

£4,500/£10,000 = 45%

£4,250/£10,000 = 42.5%

In example B above as there are only £5,000 of earnings subject to additional rate tax, full marginal relief of 45% is not achieved.

Tax relieved contributions in excess of the Annual Allowance may be subject to an Annual Allowance charge which effectively removes the relief on Pension Input Amounts  above the Annual Allowance. In addition to the Annual Allowance,  the Money Purchase Annual Allowance for those who have flexibly accessed their pension savings or Taper Annual Allowance for higher earners, may apply.

Tax Bands change from year to year but the tax bands for the following year are normally known many months in advance of tax year end.

Tax relief on pension contributions is only available up to the age of 75.

The planning

Calculate earnings in higher tax bands.

Maximise tax relief received by splitting large contributions across tax years where there is insufficient earnings in marginal bands to achieve full marginal rate relief.

The case study

Mr A has taxable income of £39,500 (after deduction of Personal Allowance) so has only £5,000 of earnings subject to 40% tax. He wants to make an £8,000 net £10,000 gross pension contribution.

Tax Year

2018/19

2018/19

2019/20

 

£8,000 net £10,000 gross

£4,000 net £5,000 gross

£4,000 net £5,000 gross

Taxable Income

£39,500

£39,500

£39,500

Tax Relief

£2,000 RAS plus £1,000 reduction in tax bill

£1,000 RAS plus £1,000 reduction in tax bill

£1,000 RAS plus £1,000 reduction in tax bill

Effective Rate of Relief

£3,000/£10,000 = 30%

£2,000/£5,000 = 40%

£2,000/£5,000 = 40%

*for illustrative purposes we have assumed the personal allowance, basic rate tax band and Mr A's salary are the same in both tax years.

By splitting his contribution over tax years Mr A has achieved full marginal rate relief on his £10,000 and gained £1,000 additional tax relief than had he made the whole contribution in the one tax year.

Reclaiming Personal Allowance

The facts

For every £2 of income earned over £100,000 an individual loses £1 of their personal allowance until they have no allowance left.

This makes the effective rate of tax 60% on income between £100,000 and £123,700 for 2018/19.

(40% tax on the £2 plus 40% tax on the lost £1 = £1.20/£2).

At income over £123,700 in 2018/19 all the personal allowance is lost.

The measure of £100,000 is the 'adjusted net income'. Broadly, this is total taxable income less certain deductions e.g. gift aid donations and gross personal pension contributions.

The planning

  • Identify total income for personal allowance purposes i.e. adjusted net income
  • Calculate excess over £100,000 limit
  • Calculate contribution to reduce adjusted net income to £100,000
  • Make the personal pension contribution in the tax year in which the personal allowance is lost.

The case study

Mr A has income of £110,000 so has lost some of his personal allowance. A personal pension contribution of £8,000 net, £10,000 gross is made.

Annual Income Distribution

 

 

The contribution has the dual impact of increasing the amount of tax free income through the reclaimed allowance as well as pushing out the basic rate band

Income against tax bands

 

For a resulting net spend of £4,000 Mr A has: reduced his tax bill by £6,000 and generated a £10,000 pension pot.

The contribution of £10,000 has saved £4,000 in tax and received relief in the pension of £2,000 - an effective rate of tax relief of 60%. 

Mitigating Bond Taxation

The facts

When chargeable gains arise on investment bonds they are assessed for income tax purposes. Broadly, the gain is divided by the amount of years the bond has been held to determine the 'slice'.

The slice is then added to the top of the individual's income to assess any tax. This means that “Income” = total income + dividends + bond slice + capital gains. However, it is important to note the full gain is added to income for the purpose of the Personal Allowance tax trap.

For onshore bonds if the slice is in the basic rate tax band then no further tax is paid (as the bond is assumed to have paid basic rate tax within the fund). If the slice falls fully in the higher rate band a further 20% tax is due, within the additional rate band a further 25% is payable. The amount of tax on the slice is multiplied by the complete number of plan years the bond is held to get the total tax payable.

The higher and additional rate tax bands are increased, in tandem, by the gross amount of a personal pension contribution.

The principles work similarly for pension contributions paid under net pay arrangements and with offshore bonds.

The planning

  • Identify earnings in higher rate tax bands
  • Calculate bond gain 'slice'
  • Calculate contribution needed to move some or all of slice into lower tax band.
  • Make the personal pension contribution in the tax year in which the bond gain is taxed

The case study

Mr A has an income of £46,350. He surrenders an onshore bond in the 2018/2019 tax year, after 10 years with a gain of £53,650. The slice is £5,500. A personal pension contribution of £4,400 net, £5,500 gross is made.

Annual Income Distribution 2

 

Income Tax Bands 2

 

The pension contribution has moved the income and slice from the higher rate tax band into the basic rate tax band.

The personal pension contribution has:

  • reduced tax payable,
  • increased the bank balance, and
  • created a pension fund

The net pension contribution of £4,400 (£5,500 gross) has saved £11,830 confirming pension contribution as a very effective method of negating higher rate tax on the encashment of investment bonds. 

Mitigating Capital Gains Tax

The facts

In the 2016 Budget on the 16 March 2016 the Chancellor announced significant changes to Capital Gains Tax commencing in the 2016/17 tax year. There was a reduction in the 18% rate of CGT to 10% and the 28% rate of CGT to 20% for chargeable gains, except in relation to chargeable gains accruing on the disposal of residential property (that do not qualify for private residence relief), and carried interest where the 18% and 28% rates still apply.

A Capital Gain is therefore taxed at 10% for non and basic rate taxpayers and 20% for higher and additional rate taxpayers.

When the gain is calculated it is added to the top of an individual's income after all other income and any slice on bond gains.

The part of the gain, if any, in the basic rate tax band is taxed at 10% and the balance at 20%.

The individual's basic rate band is increased by the amount of any grossed up personal pension contribution.

The principles work similarly for pension contributions paid gross as these reduce the taxable income.

The planning

  • Identify earnings in higher rate tax bands
  • Calculate taxable gain
  • Calculate contribution needed to move some or all of gain into basic rate tax band.
  • Make the personal pension contribution in the tax year in which the Capital Gain is taxed

The case study

In the 2018/19 tax year Mr A's earnings are £46,350 per year. He has just sold his unit trust portfolio and after his CGT allowances has a taxable gain of £10,000, which has thrown him into the higher rate tax band. A personal pension contribution of £8,000 net, £10,000 gross is made.

Annual Income Distribution 3

 

The pension contribution has pulled all the 'income' at higher rates of tax into the basic rate tax band.

For a resulting net spend of £7,000 Mr A has:

  • reduced his tax bill by £3,000
  • generated a £10,000 pension pot.

The gross contribution of £10,000 has saved £3,000 in CGT tax, received relief in the pension of £2,000, an effective rate of tax relief of 32% - the relief is greater than the tax payable on the gain.  

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