The Basics of Pension Tax Relief
When you pay into a pension scheme, you receive tax relief at your highest rate of income tax. This is done through ‘relief at source’ for basic rate tax payers, which means that for every £80 you contribute, the government adds another £20 to your pension pot, bringing your total contribution to £100. Higher and additional rate taxpayers can then claim further relief on their tax return, reducing the actual cost of their contributions.
The 60% Marginal Tax Rate
For those earning between £100,000 and £125,140, there is an unofficial 60% marginal rate of income tax. This comes about because once you earn £100,000 you start to lose your personal allowance (an amount of £12,570 on which you pay 0% income tax). This allowance is reduced by £1 for every £2 that you earn above £100,000, so when your level of income reaches £125,140, you lose your personal allowance entirely.
For those wishing to avoid the 60% tax trap, pension contributions can be invaluable. Lets take a look at an example to see how this works:
An individual earning £125,000 in the 2024/25 tax year would pay income tax of £42,432. To reduce this, they decide to make a pension contribution of £25,000.
- Relief at Source (20%):
- The individual pays £20,000 to their pension plan.
- Basic rate tax relief at 20% is automatically applied, adding another £5,000 to the pension pot.
- Self-Assessment Tax Return (Additional 20%):
- As a higher-rate taxpayer, they can claim an additional 20% tax relief on their pension contributions through their self-assessment tax return.
- Their tax bill is reduced from £42,432 to £32,432.
So, for a £25,000 pension contribution:
- The individual pays £20,000 out of pocket
- Their pension pot grows by £25,000
- Their tax bill is reduced by £10,000
- The net cost to the individual is £10,000
This example illustrates that if your earnings are between £100,000 and £125,140, it could cost you as little as £40 per £100 that you add to your pension fund.
How to Claim Your Tax Relief
Higher (40%) and additional rate (45%) taxpayers must actively claim the extra tax relief through their self-assessment tax returns. This process is vital as it can significantly decrease your tax liability. To ensure accuracy and maximise potential benefits, you might consider engaging a professional firm such as ESDG Accountancy, who offer a range of tax planning and tax compliance services.
If your income is taxed at source, i.e. you are an employee paid through PAYE and you are making private pension contributions, you can expect to receive a repayment from HMRC when you file your tax return. Therefore, you may wish to file your return as soon as possible after the end of the tax year (5th April) in order to benefit from an early repayment.
Further Benefits of Pension Contributions
Tax-Free Growth
One of the most compelling reasons to utilise pension contributions as a tax planning strategy is the tax-free growth of these investments. Without the burden of income tax and capital gains tax, your pension funds can grow unimpeded, potentially resulting in a much larger retirement fund over the decades compared to taxable accounts.
Tax-Efficient Withdrawal Options
Upon retirement, you can typically withdraw up to 25% of your pension pot as a lump sum, completely tax-free. This feature is particularly advantageous, providing a significant sum that can be used for various purposes without incurring tax. The remaining 75% of your pension can then be drawn gradually as income, which is taxed at your marginal rate—often lower in retirement, further enhancing tax efficiency.
Strategic Use of Pension Contributions
Strategically timing your pension contributions can be a powerful way to manage your taxable income. By increasing contributions in years when your income is higher, you can ensure more of your income is taxed at a lower rate, thus reducing your overall tax liability. This strategy is particularly beneficial for individuals near the threshold between tax brackets.
Expert Guidance for Comprehensive Planning
For tailored advice on how to integrate pension contributions into your broader financial strategy, consulting with experts like ESDG Accountancy can be invaluable. Their team of professionals can provide personalised guidance based on your unique financial situation, helping you to navigate the complexities of tax planning and retirement preparation.
Conclusion
Pension contributions serve as a robust tax planning tool by offering tax relief on contributions, allowing for tax-free growth, and providing options for tax-efficient withdrawals. By understanding and utilising these benefits effectively, and seeking expert advice, you can significantly enhance your financial readiness for retirement. Engaging with a knowledgeable accountant or financial advisor ensures that you maximise these opportunities as part of your overall strategy for financial success.
