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Pension tax relief for high earners explained

Everyone who puts money towards their pension is entitled to tax benefits. The tax relief comes in the form of a top-up or bonus by the government, which essentially means that some money paid towards taxes goes to the pension pot rather than going to the government. 

Basic rate taxpayers can claim a 20% tax relief on their contributions; however, the tax relief increases as the income goes up. Therefore, individuals in the higher rate of income tax payment receive an additional 20% tax relief, while those in the additional-rate tax payment band of income tax get extra 25% tax benefits. Thus, the tax relief on pension contributions keeps going up with the annual income and ends up being high for high earners.

So, it’s important for high earners to plan their contributions and resulting tax payments to reduce their tax burden. The UK government has implemented several policies to manage tax relief for high earners; however, the paying in and taking out of pension have been impacted by tighter restrictions in the past decade and have brought heavy tax burdens on high earners. Various methods like increasing your pension contributions or investing in a self-invested pension plan (SIPP) can help to reduce your tax burden while retaining more income for the future.

What is tapered annual allowance?

Individuals in the basic tax rate bracket get an annual allowance of £40,000 for up to £240,000 of adjusted annual income. This means that these individuals can contribute a maximum of £40,000 annually to their pension schemes for both the tax benefits and the long-term financial security. 

From then on, the annual allowance follows a tapered approach in relation to income. It reduces proportionately with income and goes down by £1 for every £2 of adjusted income over the threshold limit of £240,000. Thus, the maximum annual allowance is £40,000, and the minimum annual allowance after tapering is £4,000. If your adjusted annual income is equal to or more than £312,000, your tapered annual allowance will be £4,000.

The tapered annual allowance results in less tax relief for high earners. However, the loss can be compensated by taking advantage of carry forward for high earners. The unused annual allowance from the previous three tax years can be carried forward if you have a tapered annual allowance in the current financial year. As a result, you will receive an increased annual allowance in addition to a high-tax relief rate.

High earners also face a drawback in terms of their lifetime allowance for pension contributions. With the lifetime allowance significantly reduced over the past few years, individuals whose pension pot exceeds £1,073,000 when they start taking their money out may incur any additional charge for doing so. Thus, if you are a high earner and expect that your pension pot could soon reach or exceed the lifetime allowance, you must speak to your financial advisor to work out ways of what to do with the pension pot.

Impact of the expected fixed-rate tax relief reform

As we have established, pension contributions enable high earners to access tax relief and, ultimately, pay less in taxes. However, the UK government has made several changes in recent years that have increased the tax obligation for high earners and effectively reduced their income. One upcoming example of these steps is likely to include a reform to offer a 25% flat-rate tax relief on pension contributions to promote fairness and equality. The government is also looking at the new fixed-rate tax relief to recover from the debts incurred during Covid-19.

The proposed reform will be beneficial for basic rate taxpayers and mean that they receive a more generous bonus. It will end up increasing their returns on pension contributions, from the current growth of £100 to £125 to growth of £100 to £133.33 after the reform. On the other hand, this will not come as good news for high earners, as it is likely to create a dent in their future pension pots. 

With fixed-rate tax relief, their pension contributions will only grow from £100 to £133.33, compared to the current growth of £100 to £166.66. However, it seems that most taxpayers are supportive of the proposed reform to help the UK government in emerging from the heavy debt pile accumulated during the global pandemic.

Bottom line

The bottom line is that high earners do receive tax relief on their pension contributions, only their income is impacted by rules like the tapered annual allowance. While the higher tax rate relief reduces high earners’ tax bills, there is a limited amount – equal to their tapered annual allowance – they can contribute towards their pensions to avail these benefits. Therefore, it is necessary for high earners to plan their pension contributions efficiently so that they can make more and more contributions and still receive as many tax benefits as possible.

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