The countdown is on to the end of the tax year: how to save money by contributing to a pension

Nottingham-based Chartered Financial Planner Fabian Taylor, from our sister company Page Kirk Financial Services, discusses how investment in a pension can bring more financial rewards than you imagine.

As we approach the end of the tax year, it's a sensible time to think about making additional pension contributions. Not only do pension contributions normally qualify for tax relief, but there can be additional benefits to adding to your pension.

How much can I contribute to a pension?

For a UK resident, the maximum you can contribute to a pension while receiving tax relief is limited to 100% of relevant UK earnings or £3,600, whichever is higher, subject to a maximum of £40,000. This maximum is known as the annual allowance.

It is possible to pay more than £40,000 into a pension if you have unused annual allowance from the previous three years and you have been in a pension arrangement in those tax years, known as carry forward relief.

The annual allowance may be reduced if you earn over £240,000 or you have taken income from your pension.

For the purpose of pension contributions, 'relevant UK earnings' doesn't include investment income, dividends, property rental income or pension income.

Making contributions is a good way to boost your pension savings. However, for certain individuals, the benefit may be greater than just the tax relief on the contribution itself.

Child Benefit tax trap

Where an individual or couple is in receipt of child benefit, this benefit is lost where the individual - or one of the couple - earns over £50,000. Child benefit is reduced by 1% for every £100 earned over the £50,000 limit. Therefore, for an individual who earns over £60,000, the tax charge wipes out the child benefit.

The income used by HMRC in calculating the charge is known as “adjusted net income”. One way to reduce adjusted net income is to make a personal pension contribution. If the contribution is enough to get the adjusted net income below £50,000, the charge will be avoided; if it ends up between £50,000 and £60,000, the charge will be reduced.

Case study

John has a taxable income of £58,000 and his wife Mary has income of £20,000. They have two children, which results in Mary receiving Child Benefit of £1,827.80 a year.

Since John's income is £8,000 over the limit, he'll face a tax charge of 80% of £1,827.80 = £1,462.24.

As a couple, the overall value of the Child Benefit has therefore been reduced to £365.56 (£1,827.80 - £1,462.24).

If John makes net contributions totalling £6,400 in the tax year to a personal pension plan, this will be grossed up to £8,000 with tax relief. This means that his adjusted net income falls to £50,000 and no charge is payable.

By contributing £6,400, he's saved £1,462.24. Assuming all of the pension contribution lies in the higher rate tax band, he'll also be able to claim an additional £1,600 in tax relief (20% of £8,000) through his tax return. So, his £8,000 pension contribution has in fact cost him £3,337.76 (£6,400 - £1,462.24 - £1,600).

Personal allowance tax trap

If you earn under £100,000, you will usually benefit from an annual tax-free personal allowance of £12,570. When an individual earns over £100,000, the personal allowance is reduced by £1 for every £2 of income above £100,000. This means that when income is £125,140 or more, the personal allowance will be nil.

The effective tax rate for income between £100,000 and £125,140 is 60%. This is the case because in addition to paying 40% tax on any income above £100,000, there's the impact of losing some or all of the personal allowance and paying 40% tax on that income too.

HMRC uses adjusted net income to calculate the charge and so, as with the Child Benefit tax trap, making a personal pension contribution is a good way to reduce adjusted net income.

Case study

Sue has taxable income of £110,000. As a result, her personal allowance is reduced by £5,000 to £7,570.

Sue will pay higher rate tax of 40% on the amount above £100,000, amounting to £4,000, and she loses £5,000 of her personal allowance. This means an extra £5,000 is taxed at 40%, equating to £2,000. So, the £10,000 of income above £100,000 is costing her £6,000 in tax.

If Sue makes net contributions to a pension of £8,000 in the tax year, this will be grossed up to £10,000 with tax relief. This means that her adjusted net income falls to £100,000 and Sue fully regains her personal allowance.

By contributing £8,000, she regains the personal allowance, thus saving £2,000. As a higher rate taxpayer, she will also be able to claim back an extra £2,000 in tax relief (20% of £10,000) via her tax return.

Get in touch

If you would like to discuss any aspect of your pension or your wider retirement plans, please get in touch with Fabian or another member of the team in Nottingham on 0115 993 6000.

Please note

The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Levels, bases of and reliefs from taxation may be subject to change and their value depends on the individual circumstances of the investor.

Fabian Taylor is a Chartered Financial Planner at Page Kirk Financial Services LLP based in Nottingham. He advises on a range of financial matters to aid clients in the planning and arrangement of their financial affairs, including pensions; retirement planning; protection and life assurance; cash flow modelling and inheritance tax. If you would like to contact Fabian to find out how he can help you, simply call 0115 993 6000 or email enquiries@pkfs.co.uk. For more information about Page Kirk Financial Services visit their website at www.pkfs.co.uk.