Could Using a Pension Reduce Higher Rate Tax Payments?

At the beginning of March Chancellor Rishi Sunak presented his Budget. His aim: to chart a course out of the economic damage wrought by the pandemic. A year earlier he had said he would do “whatever it takes” to protect jobs and businesses. Twelve months on, with Government borrowing breaking all records, it is clear that it will take a very long time to pay the bill for “whatever it takes.”

One of the key measures in the Budget was the freezing of personal allowances: the higher 40% rate will be frozen at £50,270 from April 2021 to the 2025/26 tax year. This means that 5m people in the UK – roughly one in six taxpayers – will be paying higher rate tax by 2026 as wages rise with inflation. As many commentators pointed out, it looks like middle class savers will be paying the bill for the pandemic.

Is there any way to avoid this? Good news! – The answer is ‘yes.’ Putting more money into your pension will help you save for the future and avoid an increasing tax bill. This is because pension contributions attract tax relief at the same rate you pay income tax, meaning savers could effectively eliminate higher-rate tax bills by saving anything above £50,270 into their pensions.

Under the proposed tax freeze, someone now earning £49,000 whose pay rises by 3% per year will see their annual tax bill increase by £3,128 by 2026. However, if they put £500 per month into their pension, their tax bill will be just an extra £609 – despite them earning an extra £7,804 by the end of the Chancellor’s freeze.

What the freeze on thresholds – which also sees the basic rate threshold frozen at £12,570 – very clearly illustrates is the need for financial planning. This is not the place for complicated examples, but what is clear is that many people will enjoy significant pay rises over the next five years and will – without adequate financial planning advice – end up paying significantly more in tax.

It is worth pointing out that the freeze on thresholds also applies to inheritance tax, with that threshold frozen at £325,000. Many people will find themselves paying significantly more tax on their earnings and – without proper planning – seeing the value of their parents’ estates reduced by inheritance tax.

The Daily Telegraph described the tax rises in the Budget as ‘eye-watering,’ commenting that they take the UK back to levels of taxation not seen since the sixties. What’s clear is that the Chancellor’s decision to freeze thresholds to pay part of the bill for the pandemic makes long-term financial planning more important than it has ever been.

Contribution limits

Given the many tax advantages that are available with regard to funding a personal pension there are limits to the tax-relievable contributions that can be paid. Individuals are able to make contributions of up to the greater of £3,600 or 100% of their annual net relevant earnings to all of their pensions each tax year and receive tax relief on them.

There is an annual limit on the total amount of pension contributions that each person can make without incurring a tax charge (this includes employer and employee contributions). This is called the Annual Allowance. Where the total employer and/or individual contribution exceeds the Annual Allowance a tax charge will apply. Depending on your taxable income the excess pension savings can be charged to tax in whole or in part at 45%, 40% or 20%. For the current tax year the Annual Allowance has been set at £40,000. However, it may be possible for contributions in excess of the Annual Allowance to be paid in some circumstances under the rules, which allow unused Annual Allowance from the 3 previous tax years to be brought forward and added to the current year’s Annual Allowance.

Individuals who have adjusted income (income plus employer pension contributions) for a tax year of greater than £240,000 will have their annual allowance for that tax year restricted. It will be reduced, so that for every £2 of income over £240,000, their annual allowance is reduced by £1.

The maximum reduction will be £36,000, so anyone with income of £312,000 or more will have an annual allowance of £4,000. High income individuals caught by the restriction may therefore have to reduce the contributions paid by them and/or their employers or suffer an annual allowance charge.

The tapered reduction doesn’t apply to anyone with threshold income (income less personal pension contributions) of no more than £200,000.

If the total value of your pension benefits exceeds the ‘Lifetime Allowance’ the excess benefits will be subject to a tax charge of up to 55%. The Lifetime Allowance is currently set at £1,073,100 but it may be possible to keep a higher lifetime allowance if one of the forms of protection is applied for:

  • Individual Protection 2016 (IP2016) – available to those with total pension savings greater than £1 million on 5th April 2016. IP2016 will allow those individuals meeting certain criteria to fix their lifetime allowance at the value of their pension fund as at 5th April 2016, with the maximum protection being £1.25 million. Pension funding can continue but further funding is likely to be subject to a lifetime allowance charge.
  • Fixed Protection 2016 – doesn’t require a minimum fund value but is aimed at those who expect their pension funds to exceed £1 million at retirement. It fixes the individual’s lifetime allowance at £1.25 million but doesn’t allow any further pension funding after 5th April 2016.

A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The value of your investment (and any income from them) can go down as well as up which would have an impact on the level of pension benefits available.

Levels, bases of and reliefs from taxation may be subject to change and their value depends on the individual circumstances of the investor. Tax rates described are based on the 2021/2022 tax year. The Financial Conduct Authority does not regulate tax advice.

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