Pensions: Less tax now, more income later
Thinking and planning ahead could help you to lessen the rising tax burden.
If you find more and more of your income is taxed over the basic rate, you are not alone. The higher rate threshold – the point at which you start to pay 40% income tax – has reduced to £41,865 for 2014/15, down from £43,875 in 2010/11.
The Chancellor has announced that the threshold will rise again by just 1% for 2015/16, which is well below the expected rate of inflation. You may also be feeling the full impact of the tax on child benefit and you may find your personal allowance is reduced or even withdrawn if you earn more than £100,000 a year.
Those with the most contribute the most
The increased tax burden for higher earners is a deliberate policy, as the 2013 Autumn Statement made clear: “The government is committed to a fair tax system in which those with the most, contribute the most”. Since 2010, the government has taken action at every Budget to raise the amount of tax paid by the richest.
The role of pensions in tax reduction
If you want to reduce the amount of tax you pay, the solution is in your own hands. The generous tax reliefs successive governments have given to pension arrangements mean that they have long played an important role in tax planning for high earners.
While the reliefs remain, pensions continue to offer significant tax benefits
However, in the last four years, increasingly tight restrictions have been placed on these reliefs, just as the rising burden of income tax has made them all the more valuable. But while the reliefs remain, pensions continue to offer significant tax benefits.
Tax advantages of pension contributions
Your personal contributions to a pension normally qualify for income tax relief at your marginal highest rate. Pension contributions reduce your taxable income, so they can help you to avoid the phasing out of the personal allowance, which starts at £100,000 of income, resulting in an effective tax rate of up to 60%. Contributions can also help you to sidestep the additional rate tax band, which starts at £150,000 of taxable income, or the high income child benefit tax charge, which affects those with income over £50,000.
However, the rules on limits for tax relief are complicated, and have been revised yet again. Contributions, including deemed contributions from an employer’s defined benefit scheme (e.g. that provides a pension based on your final salary) must be kept within an annual allowance to avoid tax charges. For the tax year 2014/15, this annual allowance is £40,000, down from £50,000 in 2013/14.
Reducing National Insurance contributions through salary sacrifice
Whether or not you wish to maximise your pension contributions, it’s well worth taking some trouble with the arrangements for making them. If you are an employee, then you (and your employer) can save National Insurance contributions (NICs). The secret is for you to reduce your salary or your bonus and ask your employer to use the money, including the NIC saving, to make the pension contributions for you. The technical name for this is ‘salary’ or ‘bonus sacrifice’ and it’s all perfectly legal if you do it correctly. If you pay higher or additional rate income tax, the result could be an increase of nearly 18% in the amount being paid into your pension.
However, salary sacrifice is not always the right option because it potentially affects your entitlement to state pensions and other benefits, and possibly the maximum you can borrow for a mortgage so you should seek advice from me.
From April 2015, you will have complete flexibility over what you do with a defined contribution pension after age 55, including taking the whole amount as a lump sum.
As well as the annual allowance, there is also a lifetime allowance (LTA), which sets a ceiling on the total value of your tax-efficient pension benefits. In 2012/13 the LTA was cut from £1.8 million to £1.5 million and on 6 April 2014 it fell even further, to £1.25 million. This reduction was accompanied by the introduction of two new transitional protections, known as Fixed Protection 2014 and Individual Protection 2014, allowing you to keep an LTA over £1.25 million.
It’s now too late to apply for Fixed Protection 2014, but Individual Protection 2014 is still available. If the total value of all your pensions was over £1.25 million at 5 April 2014 this protection may be relevant to you, and you should get advice about it.
Tax on drawing benefits
When you decide to draw your pension benefits you have to decide the balance between lump sum and income. If you have a personal pension or other defined contribution pension scheme, the chances are that you should take the maximum possible lump sum. This is mainly because the lump sum is tax-free, whereas any income is fully taxable.
From April 2015, you will have complete flexibility over what you do with a defined contribution pension after age 55, including taking the whole amount as a lump sum. However, doing that could mean you face a high tax bill on it and leave you without enough income later in retirement.
The levels and bases of taxation and reliefs from taxation can change at any time and are dependent on individual circumstances.