Year end tax planning with Pension

Pension contribution is being used more and more as part of tax planning. Tax strategies involving pension can be highly effective in reducing your tax liability and are easy to implement. Higher rate and additional rate taxpayers will both benefit from these strategies, but to varying degrees. If you happen to have an income of between £100,000 and £125,000, you will benefit the most. This is because once your income exceeds £100,000, you lose £1 of the personal allowance for every £2 of income. At an income level if £125,000 your £12,500 personal allowance will be reduced to £0 if you make no further pension contribution.

 

One-off additional contribution

 

This strategy involves simply making an additional one-off contribution to your pension pot, and is available in the scenario where both you and your employer contribute a certain percentage of your salary towards pension. The main impact of making an additional contribution to your pension is to increase the range of the basic tax rate band. This results in a higher proportion income falling into the basic rate band and a lower proportion falling into the higher rate bands. Thereby, reducing the overall tax liability. Additionally, the government will top up your pension contribution by 25%!

 

Let’s look at how taxpayers falling into various tax rate brackets benefit.

 

Higher rate taxpayer – Total income between £50,000 and £100,000

The size of your basic rate band is increased by 1.25 times the amount of your contribution. For example, if you contribute an additional £10,000 into your pension, £12,500 of your income which would have been taxed at 40%, is instead taxed at the lower rate of 20%. You save £2,500 income tax. £12,500 x (40%-20%) = £2,500.

 

Higher rate taxpayer – Total income between £100,000 and £125,000

This group of taxpayers will benefit the most from pension contribution. Your basic rate band will be increased by 1.25 times the amount of your contribution, as in the previous example. AND, you will possibly restore all or part of your full personal allowance that you would otherwise lose, depending on the size of the additional contribution. The table below illustrates the tax impact.

Do not contribute more pension Contribute more pension
Gross salary £125,000 £125,000
Additional pension to SIPP £0 £20,000
Income tax due £42,500 £32,500
Pension pot increase £0 £25,000

 

In this example you gain £25,000 in your pension pot (£20,000 plus 25% the government top up) by effectively sacrificing only £10,000 (£20,000 into pension offset by £10,000 saving in tax) “up front”. Of course, you could choose to have the additional £10,000 to spend now. But you would be forgoing the benefit of an additional £25,000 in your pension pot for use in the future.

The actual sequence of events taking place will more likely be:

  • Pay £20,000 into pension in March before the tax year ends
  • Receive £10,000 tax refund in April after the tax year ends and tax return filed.

 

Higher and additional rate taxpayer – Total income between £125,000 and £210,000

You will get all the tax reductions that the above group receives. However, as your income becomes higher, your annual limit begins to taper down. The manoeuvring space is tighter, but you will still be better off than if you do nothing.

 

Salary exchange scheme

An even better way to use pension contribution to reduce tax is to participate in the salary exchange scheme with your employer. You can request your employer to divert a certain amount of your salary into your pension pot. This reduces your gross salary, hence not only your income tax, but also national insurance contribution will be reduced – a clear advantage over the one-off contribution strategy. As a result, you will receive a slightly lower monthly net salary, but accumulate a large sum in your pension pot.

 

Limitations

As is often the case in matters of tax optimisation, there are limitations attached with pension contribution.

  1. Annual limit

Currently the limit for the defined contribution scheme is £40,000. This includes the contribution from employee and employer. If both conditions below are met, the limit will be reduced by £1 for every £2 of adjusted income over £150,000. The minimum it reduces to is £10,000.

  • Adjusted income is over £150,000
  • Threshold income is over £110,000
  1. Lifetime limit

The total lifetime pension contribution is currently £1,055,000.

  1. Carry forward three years’ pension allowance

You can carry forward previous three years’ worth of unused pension allowance and combine it with the current year’s allowance. You may be able to contribute as much as £160,000 in one year. The table below illustrates how the carry forward works. In this simple example, your adjusted income is below £150,000 and your threshold income is below £110,000, hence you have the full annual allowance. It shows that you could contribute up to £110,000 into pension before this tax year ends on 5 April 2020.

Annual Allowance Contribution Made Allowance Remaining
2016/17 Tax year £40,000 £10,000 £30,000
2017/18 Tax year £40,000 £15,000 £25,000
2018/19 Tax year £40,000 £15,000 £25,000
2019/20 Tax year (current) £40,000 £10,000 £30,000
Total £160,000 £50,000 £110,000

 

 

Comparing with other tax saving strategies

Giving to charities can also reduce tax liability, but it only increases the basic rate band without restoring personal allowance once your income is over £100,000. Obviously, it does not benefit your retirement planning.

You can invest in eligible start-ups through the SEIS/EIS scheme and receive a tax reduction equal to 30%-to-50% of the amount invested. For details see my previous article. This strategy is not for everyone due to the exceptionally high risk associated with start-ups.

 

Summary

Pension contribution is an effective method to reduce income tax and is easy to implement. But note that the currently available allowances may not last forever! If your income is anywhere between £50,000 and £210,000, you will benefit from making additional pension contributions, and it is worth the effort of performing some calculations.