How to use the tax system to increase your pension
There are a number of ways you can maximise the amount of tax relief you get for your pension. Some of the most rewarding approaches you can take to boost your pension are as follow;
Make sure you utilise tax-free allowances from previous years
Currently the annual cap on the amount you can pay into a pension is £50,000. This cap will be lowered to £40,000 in April next year. You are permitted though, to use up to three years past unused allowances in one contribution. This is known as ‘carrying forward’. This means it could be possible to make a contribution of up to £200,000 in one year. For this to be legitimate though you must have earnings of at least the amount you are contributing, in the year that you are making the payment. You must also have been a member of a pension scheme during the years that you are using your allowances from.
Spread pension contributions over two or more tax years
It is not always tax efficientto pay as much as possible into your pension before the annual allowance is cut.
For example, if you earn £70,000 and pay £50,000 into your pension in one year only £27,525 of it will receive the highest rate of tax relief, which is 40%. This is because earnings up to £42,475 are taxed at the basic rate. The net cost of this contribution, after all tax relief is claimed, therefore, would be £34,500 and the average rate of tax relief would only be 31%.
If you chose to split the pension payment over two tax years though and contribute £25,000 in two consecutive years, 40% tax relief would be applied to the full amount of both contributions. The net cost in this scenario would be £30,000 and you will have saved £4,500.
Keep your personal allowance
The same way as paying into a pension can allow people to keep their child benefit; it can also allow those who earn over £100,000 to keep their personal allowance.
People who earn over £100,000 have their tax-free personal allowance (applicable on the first £8,105 of income) reduced by £1 for every £2 they earn over £100,000. Anyone who earns £116,210 or more therefore loses their personal allowance entirely.
If someone who falls into this category reduces their total taxable income to under £100,000 by making pension contributions, they will keep their full personal allowance and therefore save money.
Keep your child benefit
By paying into a pension you could be entitled to carry on receiving child benefit when it would otherwise have been cut.
Child benefit has been lessened in families where one parent earns between £50,000 and £60,000 and has been cut completely in families where one parent earns over £60,000. However the rules only apply to taxable salary and so, if your pension contributions take your taxable income to under £50,000 you can continue to receive the benefit. For a family with two children this could mean an extra £1,752 a year.
Save in an ISA until you pay higher-rate tax
If you are currently a basic-rate tax payer but are expected to move into a higher tax bracket in the coming years, it may be worth your while using an ISA until the amount of tax you pay changes. By doing this, and then moving the money from the ISA into a pension when you are paying higher tax, you will, most probably, increase your pension fund.
For example if today, as a basic-rate tax payer, you pay £5000 into a pension; tax relief of 20% will be added, taking the total amount in your pension to £6,250. Using an average assumed annual growth of 3%, in five years time your pension fund will have reached £7,245. However, if you become a higher-rate tax payer in 5 years time and, instead of putting the original £5000 into your pension you kept it in an ISA, your money could have grown at 3% to £5796 in this time. By then paying this money into a pension as a higher-rate tax payer the tax relief you receive will be at a rate of 40% and so your pension will automatically be taken up to £9,660. This is £2,415 more than if you hadn’t used the ISA.
Make the most of the 50% tax relief
The top rate of tax, which applies to earnings of more than £150,000, is due to be lowered from 50% to 45% in April this year. While this seems like good news for top earners, it also means that the top rate of tax relief will also fall.If you fall into the category of top rate tax payer and have a lump sum to available to pay into your pension, it therefore makes sense to make the contribution now whilst the top tax relief is still available.
Again, though, you may be better off making a large contribution over two tax years. This would be the case if the contribution you wish to make exceeds the amount of salary that would attract 50% tax. For example, if your earnings are £175,000, only the first £25,000 of a £50,000 contribution would benefit from 50% tax relief, the average rate of relief would be 45% and so the net cost would be £27,500. If instead you put £25,000 in this year and £25,000 next, you would receive 50% relief on the first contribution and 45% on the second, making your net cost £26,250, saving you £1,250.
If you already pay into a private pension you may be due a pension tax rebate on private pension contributions. Find out more here.