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 £125,140, 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 £125,140 your £12,570 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 £125,140
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 | £125,140 | £125,140 |
| 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 tax saving) “up front”. Of course, you could choose to have the additional £10,000 to spend now. But you would forgo 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.
Additional rate taxpayer – Total income above £260,000
For taxpayers with total income above £260,000, their annual pension allowance will be reduced. For every £2 the income above £260,000, £1 allowance is reduced. The maximum reduction is £50,000, leaving £10,000 annual allowance.
Basic and higher rate taxpayer – Total income below £260,000
For taxpayers with total income above £260,000, the annual pension allowance is £60,000. In addition, the unused allowance for the previous three years is also available to use.
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. Additionally, if you have a miss-sold SIPPs claim, it’s important to consider seeking professional advice to potentially recover any losses incurred.
Limitations
As is often the case in matters of tax optimisation, there are limitations attached with pension contribution.
- Annual limit
Currently the limit for the defined contribution scheme is £60,000. This includes the contribution from employee and employer. If the total income is above £260,000, the limit will be reduced by £1 for every £2 of income over £260,000 . The minimum it reduces to is £10,000.
- Lifetime limit
The Lifetime Allowance will be abolished from April 2024.
- 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 £180,000 in one year. The table below illustrates how the carry forward works. In this simple example, your total income is below £260,000, hence you have the full annual allowance. It shows that you could contribute up to £120,000 into pension before this tax year ends on 5 April 2024.
| Annual Allowance | Contribution Made | Allowance Remaining | |
| 2020/21 Tax year | £40,000 | £10,000 | £30,000 |
| 2021/22 Tax year | £40,000 | £15,000 | £25,000 |
| 2022/23 Tax year | £40,000 | £15,000 | £25,000 |
| 2023/24 Tax year (current) | £60,000 | £20,000 | £40,000 |
| Total | £180,000 | £60,000 | £120,000 |
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 £50,270 and £260,000, you will benefit from making additional pension contributions, and it is worth the effort of conducting some calculations.