Tax relief on personal contributions to a registered pension scheme in the UK is limited to 100% of an individual’s relevant UK earnings in a tax year or £3,600 gross pa, if higher. The taxable element of redundancy pay (that is, any amount above £30,000) counts as relevant UK earnings, as will any payments made for salary, bonus, overtime and a PILON, so there can be scope to use some or all of a redundancy payment above the tax-free amount to make a personal contribution.
If the planned contribution is above the annual allowance (either the standard £60,000 annual allowance or the tapered annual allowance if an employee is a high earner in the tax year), it’s possible to use carry forward to avoid triggering an annual allowance charge. Carry forward makes use of any unused annual allowance from the previous three tax years, with the earliest of the three tax years being used first. If an employee was subject to the tapered annual allowance in a previous tax year, the carry forward available for that year is based on the tapered annual allowance rather than the standard annual allowance.
Catherine is 50 years old and lives in England. She was the manager for a public relations agency before being made redundant, and she has received redundancy pay of £70,000.
Income tax due = (£70,000 - £30,000) x 40% = £16,000.
The net redundancy pay Catherine would receive is £54,000.
Catherine doesn’t need her redundancy pay to meet her immediate financial needs, so decides to make a gross pension contribution of £40,000 into a personal pension. This is equal to the taxable element of her redundancy pay.
The net contribution due is £32,000 taking account of basic rate tax relief of 20%. By making this net pension contribution and then claiming the additional 20% tax relief through her tax return, Catherine receives 40% tax relief (a total of £16,000) on her contribution. She has been able to offset in the full the income tax deducted from her redundancy pay.
This assumes that Catherine is a higher rate taxpayer and higher rate tax relief is available on the whole pension contribution she makes. It also assumes that Catherine is subject to the standard annual allowance of £60,000 in the tax year she is made redundant.
As a gross contribution of £40,000 has been invested into Catherine’s personal pension, she will need to have relevant UK earnings of at least that amount in the tax year to justify the contribution for tax relief purposes.