9th January 2014 at 11:59am
It’s approaching that time of year again. The Christmas adverts have made way for holiday ones. And sandwiched somewhere between the Caribbean cruise and beach holiday adverts will be HMRC telling us that “tax doesn’t have to be taxing”. It’s a reminder that the 31 January deadline for self-assessment is nearly upon us.
Apologies for breaking the party mood to talk about tax returns, but that’s because millions of pounds worth of pension tax relief goes unclaimed each year as a result of not filling one in. But I’m getting ahead of myself. There’s a whole range of tax benefits associated with saving into a pension.
Tax relief on money you pay in
If you’re paying into a personal pension or SIPP, your contributions are paid out of taxed salary. Your contributions receive an automatic 20% top-up from HMRC. So for every £100 you put in, an extra £25 will be added. But if you pay income tax at either the 40% or 45% rate, you need to take some extra steps to get the full tax benefit. The extra tax relief has to be reclaimed through your tax return. So keep an eye on that 31 January deadline.
Contributions for some workplace schemes are taken from your pay before tax is deducted. This is nice and easy – you don’t need to claim tax relief as it’s all dealt with by your employer.
Tax free cash
The tax benefit of saving into a pension isn’t just about the tax relief on your contributions. There are tax breaks on the way out as well as on the way in. Up to 25% of your pension fund can typically be taken as tax free lump sum after your 55th birthday.
You don’t pay any tax on any investment growth on your fund all the time your money stays invested in your pension.
Higher earners: getting your personal allowance back
The personal income tax allowance allows you to earn up to £9,440 without paying any tax on this income (tax year 2013/14). If you earn more than £100,000 a year, you will begin to lose your personal allowance, which means you’ll pay more income tax. Once your income is above £118,880, you don’t get any personal allowance at all. The loss of personal allowance effectively means your income above £100,000 is taxed at 60%.
Making a pension contribution can help to restore your personal allowance, which reduces your income tax bill. That’s because your pension contributions reduce the income used to test whether you are entitled to an allowance. If you earn more than £100,000, it’s possible to save up to £3,776 in income tax by making a pension contribution to reduce your income below £100,000.
For example, suppose you have a salary of £100,000 and received a bonus of £18,500 in the tax year. Your personal allowance of £9,440 is reduced by £1 for every £2 over £100,000. Paying the bonus into your pension allows you to retain your personal allowance. As a result you have effectively received tax relief of 60% on your contribution.
Parents: Keeping your child benefit
If you have dependant children and are receiving child benefit you could facing a similar problem. Child benefit is withdrawn by way of a tax charge if one or more in the household has income over £50,000. Again your pension contributions can bring your income below the £50,000 threshold allowing you to retain your child benefit. For a family with 3 kids this could be worth up to £2,449 a year.
Making a sacrifice
Even better results can be achieved if your contributions can be made by salary sacrifice. Giving up some of your salary in exchange for an employer pension contribution will provide National Insurance (NI) savings for both you and your employer.
Your employer may even agree to pay their NI savings in to your pension. This may seem exceptionally generous but your employer will be in exactly the same position as before you agreed to give up the pay.
And another benefit of salary sacrifice is that you will no longer need to claim any additional tax relief by self-assessment. So no form filling and no delays in receiving your relief.
As the end of January approaches and thoughts turn to tax returns, don’t forget these six reasons why pensions may not be taxing.
The information in this blog is not financial advice. A personal pension is an investment. Its value can go up or down and may be worth less than you paid in.