Make use of tax allowances and contribute to your pension before April 6th

Friday 2 February, 2024

Our financial advisers always recommend saving into a pension as a tax efficient way to save for your retirement.  This article reviews the basics of pension planning, but also provides detailed examples of how you can use pension contributions to reduce tax payments.

How much can you contribute into your pension?

If you are working you can contribute up to your annual earnings into a pension (or £3,600 gross if more) and claim tax relief on any pension contributions.  Contributions are also subject to an annual allowance of £60,000 (this includes both employer and employee contributions) and a tax charge applies if exceeded (and not covered by carry forward). If you are new to pensions read our pension planning information.

What tax relief is available when paying pension contributions?

Tax relief is available at a person’s nominal tax rate, anything between 20% and 45% (even non-taxpayers receive 20% tax relief on contributions to pensions operating ‘relief at source’ such as personal pensions). 

Investing into a pension on behalf of someone else 

Even people who don’t work can benefit from tax relief on pension contributions, up to £2,880 per annum. If they are under 75 years old they can then claim back £720 from the government who will top up the pension contribution to £3,600. 

This allows you to invest for adult children and grandchildren so they can save for retirement. If earning, contributions up to 100% earnings (or £3,600 gross if more) can be made with tax relief.  The annual allowance also applies.  Pension contributions made by another person still qualify for tax-relief at the recipient’s marginal rate.  

Pension contribution examples that will enable you or your children reduce their tax

How contributing to your child’s pension can lower their tax bill

If you have children who are parents themselves and at least one of them earns over £50,000, your adult child may have to pay the child benefit tax charge. You can make a pension contribution to your child’s pension, which could reduce the tax they pay. 

In this example Sam is 70 years old and father to Mary who is married with two small children.

If Mary earns £60,000 per annum in 2023/24, with two children Mary will pay £2,074 child benefit tax charge. If Sam contributed £8,000 to Mary’s pension, this is grossed up to £10,000, and Mary can claim an additional £1,946 in tax relief on self-assessment AND doesn’t have to pay the child benefit tax charge as the pension contribution reduces her adjusted net income to £50,000. This equates to a 60.20% effective rate of tax relief and Mary doesn’t have to give up valuable income. This can also be a great way for Sam to pass down wealth for inheritance tax purposes.  Read more about inheritance tax planning

How contributing to your pension as a high earner can lower your tax rate

If you earn between £100,000 and £125,140 you start to lose some or all of your personal allowance (£1 for every £2 over £100,000). However, you can make pension contributions to claim your personal allowance back.

For Example:

If John earns £125,140 per annum and doesn’t make any pension contributions, he will pay the following tax:

First £37,700 at 20% = £7540
Second £87,440 at 40% = £34976

Total tax John paid = £ 42516

However, by contributing £20,112 net to his pension, he receives £5,028 tax relief at source, so his contribution is grossed up to £25,140 and he can claim his full personal allowance back as his adjusted net income will reduce to £100,000, so his personal allowance of £12570 is restored.

John will pay the following tax:
£12,570 tax free (due to personal allowance being restored)

£37,700 + £25,140 at 20% = £12568
£49,730 at 40% = £19,892

Total tax John paid = £32,460

John regains his personal allowance of £12,570 and has reduced his tax liability by £10056, (£42516-£32,460). He also receives tax relief at source of £5,028 on his pension contribution, totalling tax savings of £15084 (£10056+5028).  This means that his effective rate of tax relief on his £25,140 pension contribution is 60%.

How you can use pension contributions to reduce or remove tax when encashing an investment bond

If Julie is encashing an investment bond and there is a potential tax on the gain, she can use pension contributions to reduce or even remove the tax by the amount of the gross contribution.  If Julie has a chargeable gain from an onshore investment bond, she will only pay income tax if the top sliced gain exceeds the higher rate tax band (£50,270).  Even If Julie’s earnings take her over this figure if she pays a pension contribution, then she can make sure the gain remains in the lower band for tax as it will be offset.

For example:

Julie has a taxable income of £55,000 and an onshore bond gain of £30,000. She has held the bond for 15 years.  As Julie is a higher rate taxpayer, If she doesn’t pay a pension contribution, she will pay £30,000 x 20% = £6,000 on all the bond gain, as onshore bonds receive a tax credit for basic rate tax so the higher-rate tax liability is 20%.

However, If Julie makes a £10,000 net pension contribution the gross contribution will be £12,500, the basic rate tax band will extend to £50,270 +£12,500 = £62,770.

Now Julie’s earnings of £55,000 and the £2,000 top-sliced bond gain = £57,000 which is below the £62,770 so Julie will not have to pay the £6,000 of tax on her investment bond as there is no outstanding liability if her earnings & pension contribution take her top-sliced gain under the basic rate tax threshold.

Julie has contributed £10,000 to her pension and received £2,500 from the government, but also saved paying £6,000 in investment bond tax.  This means her effective rate of tax relief on her £10,000 pension contribution is 85%.

Conor McClean, independent financial adviser, St Albans, Hertfordshire said: ‘We recommend anyone planning for their retirement reviews their pension contributions annually, so they make the most of the tax relief on offer.  These three examples show how useful pension contributions are for financial planning.  They show the value of getting financial advice. If you take pension advice from your local independent financial adviser they will review your financial situation, consider your incomings and outgoings, and review your cashflow planning so you know how much you can save into your pension.  It’s never too late to take financial advice. We recommend you contact your local Lonsdale Wealth Management financial adviser in  Wimbledon, Barnet, Leeds / Bradford, Stafford, Ware, Chippenham, Ringwood, Harpenden, St Albans, or complete our booking form and we will contact you.  

In Summary…

Making full use of your pension tax allowances for 2023/24 so you effectively plan your finances is vitally important for financial planning.   Pension legislation is particularly complicated which is why individuals need personalised financial planning advice.

Please note:

The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested. 

The information contained within this article is for guidance only and does not constitute advice which should be sought before taking any action or inaction.

The information is based on our understanding of legislation, whether proposed or in force, and market practice at the time of writing. Levels, bases and reliefs from taxation may be subject to change.  The Financial Conduct Authority does not regulate tax planning, estate planning or cashflow modelling.

 

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