Pensions get their fair share of bad press, but, if you look beneath the headlines you will see there are some very generous tax advantages.
Just a quick refresher; pension contributions qualify for tax relief on up to £3,600 or 100% of relevant UK earnings, whichever is the higher, up to a maximum of £40,000 per year, although carry-forward relief is available.
Tax relief is normally given at source, for example, you might make a contribution to your employer scheme directly from net pay (after tax & NI). If you contributed say, £500 (per month) the pension provider will add basic rate tax relief of £125, making a total gross contribution of £625.
This is fine, if you are a basic rate tax-payer, but what if you have earnings subject to higher rate tax (above £43,000 tax year 2016/17)?
Well, you can claim an additional 20% tax relief on contributions in respect of earnings above the higher rate tax threshold. Here’s an example -
Liz earns £55,000 per annum.
She contributes £500 per month net to her employer scheme, which, when basic rate tax relief is added, equates to a gross contribution of £625 per month (as above). Therefore annual gross contribution is £7,500.
As this level of contribution is all within the higher rate bracket (earnings above £43,000), Liz is entitled to 40% tax relief. The provider has already claimed 20% relief at source, Liz therefore needs to claim the additional 20% via her self-assessment tax return, or simply write to her tax office.
This effectively means Liz’s total annual pension contribution of £7,500 has cost her only £4,500.
I come across this a lot, where employees don’t realise they have to contact HMRC to claim higher rate tax relief themselves. If you think this is you then it may still be possible to claim. The deadline is 4 tax years after the end of the tax year for which you are claiming.
So far, so good. But for higher earners it gets even better.
How to get 60% Tax Relief
From time to time I’m approached and asked “Is it true what I read, can you really get 60% Tax Relief on pension contributions?” Well actually it is, and this is how it works –
Firstly, this only applies to people with more than £122,000 of relevant UK earnings. Your personal allowance (£11,000 tax year 2016/17) is reduced by £1 for every £2 of income above £100,000. This means when income reaches £122,000p.a, the personal allowance effectively disappears.
This gives an effective tax rate on income between £100,000 and £122,000 of 60% (Ouch!).
However, all is not lost. It is possible to effectively restore your personal allowance and claim back tax relief. This is how it works –
Bob has taxable income of £122,000 per annum and currently doesn’t contribute to a pension.
Taxable Income £122,000.00
Personal Allowance £ nil
Tax & NI £ 48,172.80
Net Income £ 73,827.20
What if Bob were to make a net pension contribution of £17,600 (£22,000 gross)?
Pension contributions are effectively deducted from gross income when calculating Taxable Income (known as Adjusted Net Income). Therefore this reduces notional income down to £100,000, thereby restoring the full personal allowance.
Taxable Income £122,000
Personal Allowance £ 11,000
Tax & NI £ 39,372.80
Pension Contribution £ 17,600
Net Income £ 65,027.20
By regaining his full personal allowance, Bob has reduced his tax liability by £8,800. He also receives tax relief at source of £4,400 on his £22,000 pension contribution. Therefore, Bob’s total saving is £13,200, equivalent to 60%.
There are further benefits and complications for those paying ‘additional’ rates of income tax (earnings over £150,000), however, I will cover this in my next post.
Mike Pimm is Director & Financial Adviser at Cotswold Financial Planning. He works specifically with clients aged 40 – 60, earning over £100k per year, as this is where his strategies are most effective.