Regaining the pounds
Pension contributions could provide the answer to paying less tax, especially in an era of government belt-tightening.
The generous tax reliefs successive governments have allocated within pension arrangements mean that they have long played an important role in tax planning.
Personal contributions to a pension currently qualify for Income Tax relief at an individual’s highest marginal rate. Thus someone who pays tax at the higher rate is entitled to 40% tax relief on contributions – assuming anything over the basic rate is claimed via their tax return – meaning that £100 invested could in fact cost just £60.
What is not so readily appreciated is that contributions to personal pensions can indirectly provide other tax advantages. For example, they can help people to regain important tax allowances.
The personal allowance is the amount that most of us are allowed to earn before we start paying Income Tax. In most cases, this is £11,000. However, the personal allowance is gradually withdrawn once income hits £100,000, reducing by £1 for every £2 of income over this limit.
Therefore, the personal allowance is wiped out when income hits £122,000, resulting in an effective tax rate of up to 60% on income between £100,000 and £122,000.
However, by making a pension contribution, people can bring their taxable income back down to £100,000 and get their whole personal allowance back. This wipes out the effective 60% tax band.
To illustrate this, let’s assume that Marcia has income of £112,000 for the tax year 2016/17. As her personal allowance is reduced by £1 for every £2 of income over £100,000, she loses £6,000 from her personal allowance. As a higher rate (40%) taxpayer, she also pays £2,400 on this extra taxable income.
However, if she makes a net pension contribution of £9,600 (£12,000 including basic rate tax relief), this reduces her relevant income to £100,000 and she recovers her full personal allowance. In addition, she claims 40% tax relief on the contribution, which amounts to £4,800. This means that the £12,000 contribution actually only costs her £4,800 (i.e. £12,000 minus £4,800 in tax relief, minus £2,400 recovered by restoring her personal allowance). This is equivalent to tax relief of 60%.
“People who earn between £100,000 and £122,000 should look for ways to escape the 60% tax rate by getting their taxable income down to £100,000. Making a pension contribution is an excellent way of doing this since it is deductible in calculating income,” says Ian Price, Divisional Director at St. James’s Place.
“Pension contributions can also help bring your income level below the additional rate tax band, which starts at £150,000 of taxable income, or the high income Child Benefit tax charge, which affects those with incomes over £50,000,” says Price.
Of course, whether paying a large pension contribution is right for you depends on your circumstances. If you are likely to need access to the money before the age of 55, putting it in a pension may not be the answer. However, for anyone who is willing to look beyond immediate income needs, pensions offer huge tax-planning opportunities.
Indeed, pensions are so tax-efficient that the reliefs currently available will inevitably remain under government scrutiny. It remains to be seen whether the government will restrict the availability of pension tax relief as part of cost-saving measures, which could be announced as early as the Autumn Statement. Thinking and planning ahead could help you to lessen any potential impact.
The value of an investment with St. James's Place will be directly linked to the performance of the funds selected and may fall as well as rise. You may get back less than the amount invested.
The levels and bases of taxation, and reliefs from taxation, can change at any time and are dependent on individual circumstances.