How to Use Your Pension to Reduce Your Tax Bill

How to Use Your Pension to Reduce Your Tax Bill

How to Use Your Pension to Reduce Your Tax Bill

Incredibly there are now more than 4 million people in the UK who qualify to pay the higher rate of tax (at a not-to-be-scoffed-at 40%). But what many of those higher rate taxpayers do not realise is that they could possibly avoid being caught by the higher rate altogether if they put more of their earnings into their pensions contributions pot.

With higher rate taxpayers now matching the peak levels of pre-recession and the threshold getting ever lower, more and more people are now being sucked into the higher rate earnings category. Similarly, existing higher rate taxpayers are now also going to end up paying that 40% rate on a lot more of their earnings. But with a slight tweak to how they manage their finances and their pensions they could make things a lot easier (and a lot less costly) for themselves. Even the smallest change to your pension contributions can mean the difference between hitting that 40% rate or completely avoiding paying tax at that level.

A Tax Break That No One Paying Higher Rates Should Miss Out On

The tax relief for pensions is so attractive, and so easy to put into place that all higher rate earners should do it as soon as they possibly can. As Laith Khalaf, a pensions analyst at Hargreaves Lansdown described it to the Financial Times,

“Higher-rate relief is a very attractive upfront tax break for wealthier pension savers – especially as they may pay only up to 20 per cent on their pension in retirement.”

Why is it so good? Because for any higher rate taxpayer every £1000 that they contribute towards their pension pot will mean £250 reduced from their tax bill and an equivalent amount of basic rate tax relief. This extra higher rate relief has to be reclaimed later through a tax return whilst the basic rate relief will be automatically added to the value of the plan, thereby boosting a contribution of £1000 to a contribution of £1250.

How would this work in practice? The best way is to take the example of a taxpayer who is earning £65,000 and who has £1000 of interest on taxable savings and who could be paying as much as £16,330 in tax for the year. That higher rate tax payer could mitigate some of that tax burden by paying as much as £14,800 into their personal pension pot and contributing also to an occupational pension and to charitable causes – thereby bringing their higher rate tax down by £4,500 and adding a total of £28,250 to their pension fund. This would mean that their tax relief and savings would be a total of £8,850, which would have otherwise have been payable at 40%.

What About If I Can’t Spare the Cash?

Sure you’re a high earner, but that doesn’t necessarily mean you’ve got a lot of cash to throw into your pension, right? However, there is another way you can take advantage of these allowances – by switching out non-pension related investments into a new Sipp (Self-Invested Personal Pension).

When Do I Need to Do This?

In order to reduce the taxation burden for the current year a taxpayer must make contributions by the 5th of April. The cash does not however need to be invested until a later date.

How Much Can I Put in My Pension Pot Then?

As of the 2013/2014 tax year, taxpayers were permitted to put as much as £50,000 into their pension pot, tax free. For 2014/2015 however the Pension Contribution Allowance will be reduced to £40,000 per year and it is thus important for those paying their taxes for 2013/2014 to make as much as possible of that year’s pension contribution allowance. It is also worth bearing in mind that any Pension Contribution Allowances for previous years that have not been used can also be carried forward into the current year, though that is restricted to the previous three years. It is nevertheless an excellent opportunity and means that someone in the higher tax bracket could potentially contribute up to £200,000 in one year. This is done by first using up the full allowance of the current year, before then claiming on the allowances of previous years.

Finally, it is worth briefly noting that if you did not for any reason pay the full national insurance towards your state pension in previous years you can also top that up – this time restricted to the previous 6 years.

How Do I Work Out How Much To Add To My Pension To Wipe Out Higher Rate Tax?

If someone thinks they could benefit from doing this they need to calculate how much income they have that sits above the 40% threshold and then times that figure by 0.8. Additionally they should bring down that higher rate figure by accounting for any other tax relief (from occupational pensions for example) first. Thus, someone earning £10,000 over the 40% tax threshold could then get 40% tax relief for up to £8000 of their contributions (once the other reliefs have been taken into account.) And if they contribute more they will get basic rate relief on any excess.

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