Pension contributions can be a valuable tool in an individual's tax planning

As well as the usual benefits of providing for a person's retirement, pension contributions can also be a valuable tool in an individual's tax planning.

This article deals with how to use pension contributions to help with tax planning on a UK (non-Scottish) basis. Scottish taxpayers will pay the Scottish rate of income tax (SRIT) on non-savings and non-dividend (NSND) income. NSND income includes employment income, profits from self-employment (including sole trades and partnerships), rental profits, and pension income (including the state pension). Similarly, from 6 April 2019 Welsh Taxpayers pay the Welsh Rate of Income Tax (CRIT (C for Cymru)) on NSND income although this is currently aligned to the main UK income tax rates.

Other tax and deductions such as Corporation Tax, dividends, savings income and National Insurance Contributions etc. will remain based on UK rules. This could mean the amount of income tax relief which can be claimed on pension contributions by Scottish and UK tax payers may not be the same. For more info on SRIT and how this works in practice, please visit our facts page. For more info on CRIT and how this works in practice, please visit our facts page.

Also see our article Reduce the impact of the high income child benefit charge.

In each situation the key facts and planning principles will be explained and then case studies will illustrate the point. In all scenarios National Insurance is ignored. Relief at source contributions are assumed, however, the same tax outcome would apply equally to relief under the net pay method.

Case studies use UK rates and allowances for the current tax year.

Tax relief is available at an individual's highest marginal rate on contributions up to 100% of Relevant Earnings (or £3,600 if higher).

Relevant earnings are broadly earned income; they exclude items such as pensions income, most rental income and dividends. More can be found on this in our 'Tax relief on member contributions' article.

Under schemes operating via relief at source (RAS) the relief is obtained in one or two stages dependant on your tax rate.

Basic rate tax relief is given automatically, the pension provider reclaims this from HMRC e.g. The member asks for a £10,000 gross contribution but only pays the net amount - £8,000 and the provider reclaims the £2,000.

Higher and additional rate taxpayers get relief through their self-assessment returns or in 'one-off claims'.
 
Higher rates of relief are achieved as the individual's basic and higher rate bands are increased in tandem by the amount of the grossed up contribution. The effect of this is income moves from the 40% tax bracket into 20% and 45% into 40%.

This means that full marginal rate relief is only available where there are sufficient earnings in the marginal band.

In example B above as there are only £5,000 of earnings subject to higher rate tax, full marginal relief of 40% is not achieved.

Tax relieved contributions in excess of the Annual Allowance may be subject to an Annual Allowance charge which effectively removes the relief on Pension Input Amounts above the Annual Allowance. In addition to the Annual Allowance, the Money Purchase Annual Allowance for those who have flexibly accessed their pension savings or Tapered Annual Allowance for higher earners, may apply.

Tax Bands change from year to year but the tax bands for the following year are normally known many months in advance of tax year end.

Tax relief on member's pension contributions is only available before the age of 75.

Calculate earnings in higher tax bands.

Maximise tax relief received by splitting large contributions across tax years where there is insufficient earnings in marginal bands to achieve full marginal rate relief.

Mr A has taxable income of £42,700 (after deduction of Personal Allowance) so has only £5,000 of earnings subject to 40% tax. He wants to make an £8,000 net £10,000 gross pension contribution.

*for illustrative purposes we have assumed the personal allowance, basic rate tax band and Mr A's salary are the same in both tax years.

By splitting his contribution over tax years Mr A has achieved full marginal rate relief on his £10,000 and gained £1,000 more tax relief than if he had made the whole contribution in the one tax year.

For every £2 of income earned over £100,000 an individual loses £1 of their personal allowance until they have no allowance left.

This makes the effective rate of tax 60% on income between £100,000 and £125,140 for the current tax year.

(40% tax on the £2 plus 40% tax on the lost £1 = £1.20/£2).

At income over £125,140 all the personal allowance is lost.

The measure of £100,000 is the 'adjusted net income'. Broadly, this is total taxable income less certain deductions e.g. gift aid donations and gross personal pension contributions.

• Identify total income for personal allowance purposes i.e. adjusted net income
• Calculate excess over £100,000 limit
  
• Calculate contribution to reduce adjusted net income to £100,000
  
• Make the personal pension contribution in the tax year in which the personal allowance is lost.

Mr A has income of £110,000 so has lost some of his personal allowance. A personal pension contribution of £8,000 net, £10,000 gross is made.

The contribution has the dual impact of increasing the amount of tax free income through the reclaimed allowance as well as pushing out the basic rate band

“Income “ against tax bands:

For a resulting net spend of £4,000 Mr A has generated a £10,000 pension pot.

The contribution of £10,000 has saved £4,000 in tax and received relief in the pension of £2,000 - an effective rate of tax relief of 60%.

When chargeable gains arise on investment bonds they are assessed for income tax purposes. Broadly, the gain is divided by the amount of years the bond has been held to determine the 'slice'.

The slice is then added to the top of the individual's income to assess any tax. This means that “Income” = total income + dividends + bond slice + savings income. However, it is important to note the full gain is added to income for the purpose of the Personal Allowance tax trap.

For onshore bonds if the slice is in the basic rate tax band then no further tax is paid (as the bond is assumed to have paid basic rate tax at the rate for savings within the fund). If the slice falls fully in the higher rate band further tax is due, within the additional rate band a further 25% is payable. 

The higher and additional rate tax bands are increased, in tandem, by the gross amount of a personal pension contribution.

The principles work similarly for pension contributions paid under net pay arrangements (which reduce the taxable income) and with offshore bonds.

• Identify earnings in higher rate tax bands
• Calculate bond gain 'slice'
  
• Calculate contribution needed to move some or all of slice into lower tax band.
  
• Make the personal pension contribution in the tax year in which the bond gain is taxed

Mr A has an income of £49,770 and savings income of £500. He surrenders an onshore bond in the current tax year, after 10 years with a gain of £50,000. The slice is £5,000. A personal pension contribution of £4,000 net, £5,000 gross is made.

Annual “income” distribution:

“Income “ against tax bands:

*By losing £135 of the personal allowance, £135 of the savings interest will be in the higher rate band of tax (even though this is covered by the 0% rate that the Personal Savings allowance provides). The income in the higher rate band before the new contribution includes the £5000 slice of the bond gain.

The pension contribution moves the income and slice from the higher rate tax band into the basic rate tax band and this has regained the amount of personal allowance that has been lost. So the bond now gains the benefit of top-slicing, as the bond is onshore the onshore credit means that there is no further tax to pay as the slice is fully in the basic rate band.

The personal pension contribution has:

• reduced tax payable,
• increased the bank balance, and
  
• created a pension fund
  

The net pension contribution of £4,000 (£5,000 gross) has saved £11,000 confirming pension contribution as an effective method of negating higher rate tax on the encashment of investment bonds.

Individuals are subject to Capital Gains Tax (CGT) on chargeable gains above their Annual Exempt Amount (AEA). The AEA is presently £3,000.

The rate of CGT they pay depends on the type of chargeable asset disposed of and what tax band(s) the gain falls into when added to their taxable income.

In Autumn Budget of 2024, the Chancellor increased the rates of "Ordinary" CGT with immediate effect from 10% and 20% to 18% and 24% for basic and higher rate CGT which now matches the rates applicable to residential property.

For most retail clients, chargeable capital gains typically occur on the disposal of investments such as shares,  Open-Ended Investment Companies (OEICs) and Unit Trusts respectively, or on sale of residential property that is not their main residence. A gift of such an asset other than to their spouse would also be treated as a disposal

CGT can also apply on other assets such as business property and carried interest but that’s beyond the scope of this article.

A few key points:

• ·Unused personal allowance cannot be applied to chargeable capital gains.
• The part of the gain, if any, in the basic rate tax band is taxed at the appropriate basic rate of CGT for the type of asset and the balance at the appropriate higher rate.
• Special rules apply if the individual triggers chargeable event bond gain in the same tax year. When calculating the CGT liability on the capital gain, only the top-sliced gain (not the full bond gain) is added on top of other income.
• The individual's basic rate band is increased by the amount of any grossed up personal pension contribution.
• The principles work similarly for pension contributions paid gross as these reduce the taxable income.

• Identify earnings in higher rate tax bands
• Calculate taxable gain
  
• Calculate contribution needed to move some or all of gain into basic rate tax band.
  
• Make the personal pension contribution in the tax year in which the Capital Gain is taxed

In the current tax year Mr A's earnings are £50,270 per year. He has just sold his unit trust portfolio and after his CGT allowances has a taxable gain of £10,000, which has thrown him into the higher rate tax band. A personal pension contribution of £8,000 net, £10,000 gross is made.

The pension contribution has pulled all the 'income' at higher rates of tax into the basic rate tax band.

For a resulting net spend of £7,400 Mr A has:

• reduced his tax bill by £600
• generated a £10,000 pension pot.
  

The gross contribution of £10,000 has saved £600 in CGT tax, received relief in the pension of £2,000, an effective rate of tax relief of 26% - the relief is greater than the tax payable on the gain.