Three ‘other’ reasons to pay pension contributions
The most obvious reason to pay pension contributions is to build up a pension pot to help fund income in later life. To encourage people to do that, the Government gives a set of generous tax advantages.
But there are other good reasons to pay pension contributions, usually to artificially adjust income. Here are three ideas to consider with your clients in the run up to the tax year end.
1. To increase a personal allowance
Those whose income is over £100,000 will lose some or all of their personal allowance (it is reduced by £1 for every £2 of income over £100,000, and will be nil if the income is £125,000 or more). This means the effective tax rate for income between £100,000 and £125,000 is 60%. By making a pension contribution, clients can reduce their ‘adjusted net income’ and so regain some or all of their personal allowance, receiving an effective 60% tax relief on their pension contributions.
2. To increase your Child Benefit
An Income Tax charge applies to people who receive Child Benefit and whose income (or partner’s income) is over £50,000. If the client’s income is between £50,000 and £60,000, then the tax charge is a proportion of the Child Benefit received. If their income is over £60,000, then the tax charge wipes out the Child Benefit received.
Again, by making pension contributions, clients can reduce their ‘adjusted net income’ and so may be able to gain back some or all of their Child Benefit.
3. To reduce your annual allowance taper
Annual allowance is reduced – or tapered – for higher-earning clients, gradually reducing down to a minimum of £10,000. To qualify for the taper, the client’s ‘adjusted income’ has to be over £150,000 and their ‘threshold income’ over £110,000. Broadly, the threshold income is calculated as their taxable income less any member contributions paid to a ‘relief at source’ pension scheme.
Clients may therefore be able to pay pension contributions to reduce their threshold income under the £110,000 mark and so avoid the tapered annual allowance applying.
Emily has income, made up of salary and dividends, worth £115,000 which is subject to Income Tax in the 2019/20 tax year.
She wants to maximise her pension contributions in this tax year by using this year’s annual allowance and carrying forward unused annual allowance of £40,000 from a previous tax year.
If the employer pays the full £80,000 contribution (not through salary sacrifice), Emily’s adjusted income would be £195,000, and her threshold income would be £115,000. She would be subject to a tapered annual allowance of £17,500. The excess contribution of £22,500 would be subject to an annual allowance tax charge.
But if the employer pays £75,000 pension contribution and Emily pays £5,000, the adjusted income would be £190,000, but the threshold income would be £110,000, meaning the taper no longer applies. The full £80,000 pension contribution can be made without an annual allowance charge.
In all of these examples, the amount of pension contributions a client can make will depend on their taxable income and the amount of available annual allowance they have. Of course, they may be able to boost the latter by carrying forward any unused annual allowance from the previous three tax years.
These examples show there can be a number of reasons why paying pension contributions can make a positive impact on a client’s finances.
This article was previously published by FT Adviser