Pensions needs its own blog topic, and there are two reasons why.
Firstly, because pensions have been messed about with so much that allowances and rules are different for different people, so we need to cover a few different examples.
And second, because pensions can be an incredibly good way of saving for retirement and making your income more tax-efficient now, so it needs the time and space to properly explain the tips to achieve that.
This is a more technical post, which is unavoidable, as there is a fair amount of tax to cover. But, as ever, we will try to speak in plain English and not lose you along the way!
Why put money into pensions?
Let's start with the obvious - pensions are designed to build funds ahead of retirement. Most of us aren't saving enough for retirement, so as the most basic of reasons, pensions do this well.
Over and above this, they can also can be incredibly valuable as a tax-planning tool for you now.
That mind sound a little odd, given that pensions are designed as a savings tool for later on.
They do this, however, through two key tax-efficiency features:
Tax relief at your highest tax rate
They reduce your income for the year to provide your 'adjusted net income'.
Tax Relief
If you make personal contributions to a pension, you'll get basic rate tax-relief automatically applied.
Let's take an example of contributing £8,000 in to your pension. It'll look like this:
Hey presto, £10,000 goes into your pension.
Hopefully to grow in the years ahead before retirement. Growth on the money you put in, and growth on the tax relief part.
Higher Rate tax-payers
If you're a Higher Rate tax-payer, you can also claim back a further £2,000 in tax relief in your tax return.
You'd therefore get £10,000 in your pension, plus £2,000 back, meaning it has cost you £6,000 to put £10,000 into pension.
Additional Rate tax-payers
If you're in the 45% tax bracket, you'll get the £2,000 immediate tax relief, just like basic rate and higher rate tax-payers, but you'll get £2,500 in your tax return.
But remember, you do need to claim it, it won't happen otherwise!
Some warnings on limits and allowances
Just be careful that you are limited to £60,000 annual allowance of contributions. This limit includes personal contributions, tax relief automatically applied and any employer pension contributions.
You also need to be careful that you do not contribute more than your earnings to pensions in any given year. If you do, you won't receive tax relief on the amount over your total earnings.
For those with total income over £200,000 your annual allowance of £60,000 may be tapered down, so you need to be really careful working out how much you can put into pension. This is something we can help you work out.
Reducing your 'net adjusted income'
Another reason pension contributions can be valuable, is that some types of contributions have the effect of reducing your income in the year contribute.
Making pension contributions means you end up with a lower 'adjusted net income'.
In plain English, this simply means reducing how much of your income is taxable. This is one of those pension tips that not a lot of people know about.
Our tax system is a little odd, so don't worry about the terminology, just know that bringing down your total income through pension contributions can be a big help.
So, which are the situations it can be valuable?
60% Tax Trap
For those people earning above £100,000, there could be a significant benefit to putting money into pension, as otherwise you'll be paying tax at an effective 60% rate on a chunk of your income.
This occurs because of the tapering of the Personal Allowance. The Personal Allowance is the amount of income you can earn before paying income tax, and is gradually reduced once your income exceeds £100,000.
For every £2 of income above this threshold, your Personal Allowance is reduced by £1. This effectively results in an additional 20% tax on income between £100,000 and £125,140 (for the 2023/24 tax year), on top of the usual income tax rates.
As described in the 'child benefit' and 'higher and additional rate taxpayer' sections above, if you can reduce your adjusted net income down below £125,140, you will start making some serious tax savings.
Meet Jenny
Jenny earns £130,000 from her job working as a programmer. She doesn't need all of her income, and is happy saving some for retirement.
On current (2023/24) tax rates, she'll take home £79,932.40 over the course of the year.
For ease, let's call it £80,000. This works out to be £6,666 a month.
That means she's paying £50,000 in Tax and NI, or an effective tax rate of 38%. Ouch.
If Jenny instead puts £30,000 into her pension, it gets topped up automatically by tax relief to £37,500. She can then claim a further £7,500 back in her self-assessment tax return.
The effect is that her 'adjusted net income' for the year is £100,000, and because of this, she regains her Personal Allowance.
She'll take home £67,803 instead of £80,000. Meaning take-home pay of £5,650 a month, around £1,000 less than when not making pension contributions.
Looking at it visually may help.
Look how much of the picture is red (tax) in the top line, with no pension contribution being made.
The red section is a lot smaller in the second line, with other benefits compensating for the loss of some take-home pay, such as tax back from her self-assessment return and money going into pension to save for retirement.
Child Benefit
If you've got children under 16 and you (if you're on your own), or you and your partner/spouse, have income of £50,000 a year or less, you should get full child benefit.
If one of you, or both of you earn over this, the benefit tapers down, until one or both of you earn over £60,000, and then you effectively get nothing, as it all gets paid back in tax if you claim it.
The rules actually state that the benefit payment is assessed on your 'adjusted net income'.
Lets say you earn £55,000 salary and have a child. As is stands, you'll lose half your child benefit allowance, meaning you'll miss out on £624 a year.
If you were to put £5,000 into pension as a personal contribution (not via work payroll), the government would add £1,250 as tax relief, so £6,250 would go into pension.
Your adjusted net income would reduce to £50,000 and you would get back all of your child benefit allowance. So you would get:
£624 back in child benefit
£1,250 tax relief into your pension
An extra £946 tax relief to claim back via your tax return as higher rate tax relief.
Total of £6,250 saved for retirement, with an extra £1,570 back in child benefit and higher rate tax relief.
That's £7,820 total benefit from £5,000 of your money.
Action - see if making a lump sum pension contribution would make a difference to your tax position, but only if you can afford to do it!
Some things to be aware of:
When making contributions, you need to be aware of the annual allowance rules
If you have income of over £200,000 you may be subject to the tapered annual allowance
All of the examples above are based on making personal contributions, that is contributions not through an employer pension or through a business.
If making contributions through your workplace pension or as an employer contribution through a business, the calculations change and we'd be happy to discuss these with you.
See! pensions can be a lot more interesting than on the face of it.
No? just me? well, you can't say I didn't try!
If you'd like to help with pensions and making your income more tax-efficient and work harder for you, come and book in a chat here:
Otherwise, see you next time.
The information contained within this blog post should not be taken as financial advice, as it does not take account of personal circumstances, which would affect advice given. Should you wish to talk to us about personalised advice for you, we'd be happy to do so.
Tax rates are based on the tax year 2023/24.
