Article Pension contributions as a tool for tax planning

Speculation on possible changes to pension tax relief is nothing new. Attention often centres on this very valuable, but costly, tax benefit prior to any Budget announcement or economic statement.

In June 2020, former Chancellor – and now Secretary of State for Health and Social Care – Sajid Javid, and The Centre for Policy Studies, produced a joint report, urging the government to consider axing marginal rate pension tax relief in favour of an alternative flat-rate bonus, and reiterating the idea of an ISA-style pension. A recently updated briefing paper from the House of Commons Library also discusses a reform of pension tax relief. Whilst current Chancellor Rishi Sunak has so far resisted the temptation to make fundamental changes to pension tax relief, his March 2022 Spring Statement Tax Plan makes reference to future simplification of the current tax system and reform of the various tax reliefs in operation in the UK ahead of 2024.

With all this in mind, and the freezing of the tax-free personal allowance and basic and higher rate tax bands until April 2026, has there ever been a better time for clients to consider making pension contributions? A contribution made personally to a registered pension scheme reduces a client’s ‘adjusted net income’ – broadly their total taxable income before any personal allowances less certain deductions. This in turn lowers the amount of income tax they pay, protects certain tax benefits and allowances and boosts the level of their pension savings. This presents a wide range of tax planning opportunities, as the following examples demonstrate.

Low and non-earners

Personal contributions of up to £3,600 or 100% of ‘relevant UK earnings’ if greater can be made to a registered pension scheme by a low or non-earner, be that by the client themselves or perhaps on behalf of a non-working spouse, partner, child or grandchild. If the personal contribution is made to a registered pension scheme operating tax relief at source – typically a personal pension – the contribution will attract basic rate tax relief, even if the individual does not pay any income tax.

Clients living in Scotland paying the starter rate of income tax at 19% on taxable income (between £12,571 and £14,732), also benefit from basic rate tax relief on their personal contributions to a registered pension scheme, operating tax relief at source, and are not required to refund the 1%.

Crossing into higher rate tax

The standard tax-free personal allowance across the whole of the UK for 2022/23 is £12,570. In England, Wales and Northern Ireland, basic rate tax at 20% applies to the next £37,700 of taxable income. Assuming there are no benefits in kind or unpaid taxes, a client based anywhere in the UK outside of Scotland will pay higher rate tax at 40% on any income above £50,270 up to £150,000.

If a client has a total income of say £54,270, he or she will pay higher rate tax at 40% on £4,000. Alternatively, the payment of a personal contribution of £3,200 net to a registered pension scheme operating tax relief at source – or £4,000 paid to a registered pension scheme operating under the net pay arrangement, typically an occupational scheme – will reduce the client’s ‘adjusted net income’. This means the client will avoid paying any higher rate tax.

In Scotland, there’s a lower threshold of £43,663 before higher rate tax is payable and a higher rate of tax applying at 41%. This makes an even more compelling case for making personal contributions to reduce ‘adjusted net income’ for clients living north of the border. The intermediate tax rate at 21% in Scotland on taxable income (between £25,689 and £43,662) means that affected clients will need to claim the extra 1% tax relief from HMRC – it’s not given automatically.

Child benefit

Clients who have income over £50,099 and who have children qualifying for the payment of tax-free child benefit, may be interested in making personal contributions to a registered pension scheme. Where a client, or their partner, has income above £50,099, a tax charge will apply to the person with the higher income equal to a 1% deduction in the child benefit award, for every £100 of ‘adjusted net income’ exceeding £50,000. The benefit is effectively lost completely if income reaches £60,000 or more.

A personal contribution to a registered pension scheme may allow this valuable benefit to be retained in part or full. For example, a client with two qualifying children earning £55,270 would see their entitlement reduced from £1,885 per year to £905 per year due to the tax deduction. The payment of a personal contribution of £4,136.80 net to a scheme operating relief at source, would reduce their adjusted net income to £50,099 and retain their full entitlement to the tax-free child benefit of £1,885, at a net cost of £3,136.80, after claiming higher rate tax relief on the personal contribution. A personal contribution of £5,171 to a registered pension scheme operating under the net pay arrangement would achieve the same result.

Loss of the tax-free personal allowance

Clients will see their tax-free personal allowance withdrawn by £1 for every £2 of ‘adjusted net income’ above £100,000 – and lost completely if income reaches £125,140 or more. For a client with taxable income of £125,140, the payment of a personal contribution of £20,112 net to a registered pension scheme operating tax relief at source – or £25,140 paid to a registered pension scheme operating under the net pay arrangement – will reduce their ‘adjusted net income’ to £100,000. This will reinstate their full tax-free personal allowance and give an effective rate of tax relief on the whole contribution at 60%.

Carry forward

The carry forward provisions allow clients to contribute more than the annual allowance in a tax year without incurring a tax charge. Broadly, if the client has been a member of a registered pension scheme in one or more of the previous three tax years – and hasn’t used all of their annual allowance in those years – the unused amount can be carried forward to the current tax year, once their annual allowance in the current tax year has been exhausted. Tax relief on any personal contribution will only be available up to 100% of the client’s ‘relevant UK earnings’ in the current tax year even where carry forward is being used. The ability to carry forward is also available to those high earners who are subject to the tapered annual allowance. However, it isn’t available for contributions to defined contribution schemes for those who have triggered the money purchase annual allowance.

Additional rate tax

Clients with taxable income of £150,000 or more will pay income tax at an additional rate of 45% in the 2020/21 tax year in England, Wales and Northern Ireland – and at a top rate of 46% in Scotland.

The payment of a personal contribution to a registered pension scheme within the annual allowance, or the tapered annual allowance where this applies, plus any unused annual allowance carried forward from any of the previous three tax years – will increase the income threshold beyond which the additional rate, or top rate, applies. This maximizes the level of pension tax relief on offer.

Tapered annual allowance

High earning clients who’ve been affected, since 6 April 2016, by the tapered annual allowance provisions – and have previously ceased or limited their contributions – should be encouraged to review their ability to contribute if this hasn’t yet happened. This is in light of the increases on 6 April 2020 to both ‘threshold income’ and ‘adjusted income’ to £200,000 and £240,000 respectively. All clients with ‘adjusted income’ between £150,000 and £300,000 saw an increase in the amount they could pay from 6 April 2020, some by as much as £30,000.

The new provisions unfortunately also meant that those with ‘adjusted income’ of more than £300,000 saw a reduction in the amount they could pay from 6 April 2020 without incurring a tax charge. The annual allowance is reduced by £1 for every £2 of ‘adjusted income’ above £240,000 – subject to a minimum of £4,000 for those with ‘adjusted income’ of £312,000 or more. Any existing contributions for affected clients will need to be reviewed, if this hasn’t yet happened.

Those intending to take benefits

Clients intending to ‘flexibly access’ their defined contribution pension benefits (for example by taking income from flexi-access drawdown) – and who are keen to continue making pension contributions – need to bear in mind the money purchase annual allowance. This allowance applies to contributions to defined contribution schemes after certain trigger events and is currently set at £4,000 per tax year. The money purchase annual allowance is not triggered where someone takes a pension commencement lump sum but no income from flexi-access drawdown.

For clients who are affected, it’s also no longer possible from that point on to carry forward any unused annual allowance from the previous three tax years for contributions to defined contribution schemes. Any clients looking to take benefits and who wish to maximize their pension savings, will need to consider making contributions before triggering the money purchase annual allowance. .

Salary sacrifice

As an alternative to making personal contributions, employed clients at all salary levels could look to consider the use of salary and/or bonus sacrifice to achieve similar results as above. Such clients will not be liable to income tax or National Insurance contributions (including the new 1.25% Health and Social Care Levy) on the salary and/or bonus sacrificed. The employer will pay the sacrificed amount as an employer pension contribution, with the option of adding part, or all, of its own National Insurance saving, to boost the level of pension contribution further.

Higher and additional tax reclaim

Personal contributions made to registered pension schemes operating under the net pay arrangement are paid gross and deducted from a client’s income before tax is applied, and therefore tax relief is available immediately at the highest marginal rate.

Personal contributions made to registered pension schemes operating tax relief at source are paid net of basic rate income tax – currently 20%. The scheme claims the basic rate tax relief from HMRC and applies this to the client’s pension arrangement.

It’s very important that clients are aware that they might be entitled to additional tax relief and that they must claim this from HMRC – it’s not given automatically. This may be for higher and additional rate tax relief in England, Wales and Northern Ireland and for intermediate, higher and top rate tax relief in Scotland. Historically, many clients have failed to claim their full tax relief entitlements. Indeed, analysis from last year suggest as much as £810 million may have gone unclaimed in higher and additional rate tax relief for tax year 2018/19.¹

Clients can claim any additional tax relief via their Self-assessment tax return. They just enter the gross personal contribution in the relevant section of the annual Self-assessment form, and tax relief will be given either by changing the client’s tax code, by tax rebate or by reducing tax already due to HMRC.

Alternatively, if the client doesn’t usually fill in an annual Self-assessment form, or they don’t want to wait, they can contact their local tax office in writing or by telephone with details of the personal pension scheme that personal contributions are being paid to, the date that the contributions started, and the gross amount of the personal contributions paid. The local tax office will then arrange for their tax code to be changed so that additional tax relief is available throughout the year in which the contributions are being made.

Not only a tax year end exercise

Typically, tax planning exercises often take place towards the end of the tax year and perhaps at the start of a new tax year. However, in view of current uncertainty, we believe it’s a continual process and always the right time to consider the full range of tax planning opportunities that exist in making pension contributions.

Recommending the payment of a pension contribution may help clients reduce the amount of income tax that they pay, retain their entitlements to existing tax allowances and benefits and boost the value of their pension savings, adding real value to the adviser/client relationship. Advisers should review their client bank, segment their clients into the appropriate income bands and target their communications and activity appropriately.

Whilst the future for pension tax relief is unclear, one thing that’s certain is that personal contributions paid now will attract the levels of tax relief that are currently available. Yes, it’s possible that the Government might make changes to the pension tax rules in future – but if tax relief has already been received and banked it can’t then be taken away.

This information is based on our understanding of current taxation law and HMRC practice, which may change. The value of any tax relief will depend on individual circumstances.