With the end of the tax year approaching, now is the time for high earners to consider their own tax situation and to consider making pension contributions to avoid paying more tax than is necessary.
This is especially relevant for those earning close to £100,000. Missing out on pension contribution tax relief can be a costly mistake. An effective 60% tax rate for earnings between £100,000 and £125,000 means that, if you haven’t filled your pension contribution for the tax year, you could be missing out on significant tax savings.
Get in touch today to discuss how pension contributions can make a difference to your tax benefits.
Tax relief on pension contributions
The pension tax relief system is imperfect, which leads to many higher earners failing to claim their relief. Reports have found that, in recent tax years, the figure for unclaimed pension tax relief in the UK is in the hundreds of millions of pounds. It’s important for those with higher incomes to avoid overpaying the taxman unnecessarily.
For every £2 of income earned over £100,000, an individual’s personal tax free allowance is reduced by £1. With no limit on reductions, high earners can end up with no personal allowance left, meaning that they are taxed a further 40% on this income. When the impact of losing some or all of your personal allowance is taken into account, the effective rate of tax on income between £100,000 and £125,000 is around 60%.
To help you visualise this tax trap, the first £1,000 above £100,000 would give rise to a £400 (40%) income tax payment, and a simultaneous loss of £500 from your personal tax-free allowance. This amount is then taxed at the higher rate of 40%, costing you an additional £200, thus leaving you with just £400 out of the £1,000 – an effective 60% tax rate.
Lower effective tax rate with pensions
One accepted and effective solution to reducing your effective tax rate lies in pensions, which reduces the income that is assessed against the £100,000 threshold. Therefore, for those earning over £100,000, making pension contributions to take their income below the threshold can result in meaningful tax savings.
The calculation for the loss of tax-free personal allowance only looks at your income after subtracting pension contributions, meaning that an individual earning £118,000 a year would have to contribute £18,000 or more to a pension to completely avoid the effective 60% tax rate. Individuals can save for the future while reclaiming the tax relief lost by their high earning.
The way to plan these contributions is, firstly, to identify total income for personal allowance purposes – your adjusted net income. Then, calculate the amount you earn over the £100,000 limit and calculate the contribution necessary to reduce your adjusted net income to £100,000 or less. Finally, make the contribution to your pension in the current tax year.
How much can I put away?
The tax-free pension allowance for each tax year is currently £40,000. This means that anyone earning up to £140,000 can take advantage of this year’s pension contribution allowance and take down their effective tax rate.
One tool for those earning more than £140,000 to utilise is the carried forward pension allowance to take their effective income below the £100,000 threshold. Essentially, savers can access any unused pension allowance from the previous three tax years. This unused allowance is added onto the current tax year’s, opening up opportunities for large deposits. Read our blog on carried forward pension allowances here.
Calculating the best way to allocate your funds can be a time-consuming and confusing task. If you want to talk through your situation, get in touch with the Moneyfarm team.