A common questions asked by people I speak to on a daily basis through my employment. Is how can I reduce my income tax liability ?. So I can legally pay less tax or drop into a lower tax bandings. A great way to start is to contribute into your pension.
At present one of the most beneficial advantages to a UK pension scheme. Is that all investment growth and returns are tax-free and Inheritance tax free within the pension wrapper.
Whereby people are offered tax efficient incentives so they make contributions into a pension scheme. At present an individual can contribute £ 60,000 per tax-year into a pension. Or a lower amount up to their earnings level. So if you are earning £ 30,000 you are allowed to contribute up to that amount.
This annual amount is beyond the reach of most people, but it could be very tax efficient for big earners. Now that the LTA of £ 1,073,100 has been recently abolished. Although you are still restricted to a maximum tax free cash lump sum being £ 268,275 (25% or the recent LTA).
A common question often asked ?
As someone who pays 40% income as a higher rate tax-payer can I make contributions. So in effect become a 20% basic rate tax-payer ?.
Quite simply, yes you can !. You can contribute into a workplace pension, private pension or a SIPP, where you can control your own investments and level of contributions.
You may consider the following,
- What is my current gross salary ?
- If I’m in a simple workplace AE scheme, what level of contributions are paid as minimum amount ?
- Will my employer let me increase my contributions ?
- If I increase my contributions, will it be matched by employer ?
- Does my employer offer something called salary sacrifice ?
- Can I afford to increase my level of personal contributions ?
- Am I restricted as to where my contributions are invested ?
At present through simple workplace Auto enrolment scheme, you contribute 4%, the employer will contribute 3% and HMRC will add 1% as tax-relief automatically. So 8% in total, although there are constant calls for this amount to be increased. As most people are not seen to be contributing enough into pensions to build a sizeable pot for access in later years.
So what are the current tax bandings ?
Tax free personal allowance: £ 0 to £ 12,570
20% basic rate: £ 12,570 to £ 50,270
40% higher rate: £ 50,270 to £ 125,140
45% additional higher rate: over £ 124,141
These rates are currently frozen since April 2021 and will remain in place at current levels until April 2028. Remember different income tax brackets apply to people living in Scotland.
See tax bandings via gov.uk: https://www.gov.uk/browse/tax/income-tax
As a result of the rates being frozen, millions of people have unknowingly been placed into higher brackets, due to receiving annual pay or salary increases. A simple example it is believed that around 3 million people have gone from the basic rate to higher rate through default. If rates stay frozen as planned more people will be pushed into higher brackets moving forwards.
So what are the tax relief implications by contributing ?
With regard to workplace pensions they are normally taxed through PAYE, so if you are earning £ 50,000 and you contribute £ 5,000. You annual income is classed as £ 45,000 so you end up paying less tax and NI and you are considered to earnings a lower salary. If you are earnings £ 55,000 income and you contribute £ 10,000 per annum into a pension, you will be classed as earning £ 45,000 , so you in effect drop to becoming a basic rate tax payer.
Most employers offer a simple solution called salary sacrifice, run through their payroll as an incentive to get employees to save into their workplace pension.
If you are contributing to a personal pension or a SIPP, you make a contribution from taxed income. The UK government will then claim on your behalf, and tax relief will be added into your pension. This is normally done the following month and paid directly into your pension.
A simple example:
If you contribute £ 100 each month, they will add £ 25 free money if you are a basic rate payer via tax-relief the following month.
A higher rate tax payer would be paid the basic amount of tax-relief and they would then have to claim additional tax relief. Usually through a self-assessment form via gov.uk.
If you don’t want to or complete self-assessment forms you can contact HMRC direct. HMRC will then adjust your basic rate tax band by the gross pension contributions paid by stated individual. this could result in a tax refund being paid, or adjustment to your annual personal allowance. However you only get a tax refund on the amount of contribution that you pay a higher rate tax on.
Different tax rules apply in Scotland !
With regard to the rules in Scotland, savers will still receive the basic rate of 20% tax relief, even though they may pay tax at 19% (known as starter rate). They can then claim additional rates at 1%, 22%, 25% or even 28%, dependent on which tax bracket they belong to.
Hopefully the above has given you some invaluable information about how tax relief works. So as part of some astute planning and forward thinking you can drop down to a lower tax bracket. Pension are considered one of the most tax-efficient products in the world of saving and investments. They make it attractive on the way in by contributions, but it then becomes taxable on accessing in later years.
See attached link on gov.uk for greater information on tax relief: https://www.google.com/url?sa=t&source=web&rct=j&opi=89978449&url=https://www.gov.uk/tax-on-your-private-pension/pension-tax-relief&ved=2ahUKEwjIwoSeh-OIAxVyQUEAHSAfGZYQFnoECAkQAQ&usg=AOvVaw2yV_xBsJD3Kxxr2X-edfNC
Under current rules, you are allowed to take 25% tax-free from your pot in future. So the bigger your pot becomes the greater the tax-free lump sum on offer. But any income you draw afterwards, via an annuity, drawdown, lump sums or cashing in completely is then taxable. It would be added to other income received in that respective tax year.
Another point to add is the minimum pension age to access your pension is currently 55. (unless you have ill-health or protected age). But this will rise to age 57 in April 2028. So give careful consideration to putting excess funds into a pension, as you may be restricted when you can access in future years. It may not be a problem for middle aged people, but it may be a problem for those of a younger age. As a result of needing money quickly or in an emergency, you will have to access via other alternatives.
If you found the above information useful, then check out my other blog posts about pensions, savings and investments. So you too can increase your knowledge on https://moneyminted.co.uk
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