Tax year-end pension tips
The tax year end is fast approaching and higher earners may want to make the most of the tax relief available to them on pension contributions.
The top rate of tax falls from 50% to 45% in the 2013/14 tax year, which also means a reduction in pension tax relief for those affected.
By making additional pension contributions before 5 April, 50% taxpayers could save thousands of pounds.
There are a number of practical steps that people can take to maximise available tax reliefs and reduce potential liabilities in the run up to the new tax year.
For higher earners, it makes sense to make the most of the three-year carry-forward rule. This allows individuals who have used up all of their current tax year's allowance to use any unused pension allowance from 2009/10, 2010/11 or 2011/12.
If a person has used all their £50,000 annual allowance in the 2012/13 tax year, carry-forward may be a useful tax-planning tool that will allow them to make a large pension contribution without being penalised for breaching the £50,000 annual pension allowance.
If no pension contributions had been made in any of the three preceding tax years, an individual may be able to contribute an extra £150,000 into their SIPP in the current tax year. If they are a top rate taxpayer, they would also benefit from the current 50% income tax relief available to them on pension contributions, which will fall to 45% from April this year.
60% tax relief on pension contributions for people earning more than £100,000.
The personal allowance is the initial portion of income which most people receive that is free of any tax. At the moment this amounts to £8,105.
Since 2010/11 any individual earning more than £100,000 will have seen their personal allowance reduced, potentially to nothing, because for every £2 earned over £100,000 the personal allowance is reduced by £1. Anyone earning more than £116,210 in the 2012/13 tax year will not benefit from any personal allowance at all.
So as well as paying 40% tax on the earnings from £100,000 to £116,210, they are losing their band of earnings which is free of tax at a 20% rate. They are effectively paying up to 60% tax on this portion of their earnings.
Pension contributions are deducted from an individual's income before the personal allowance is calculated.
Clients with an income above £100,000 may wish to consider the payment of pension contributions in order to bring their income down to a level where they will not face a reduction in their personal allowance – or to put it another way, they could effectively receive 60% tax relief by making these contributions.
Reduce taxable income
The main benefit of pension contributions for higher or additional rate taxpayers is that the tax relief reduces the amount of income which is subject to tax at either 40% or 50%.
So, for example, someone with £10,000 of their income subject to tax at 40% could make an equivalent contribution into their SIPP to completely remove any liability to tax at 40%.
A person earning £60,000 pays tax at 20% on £34,370 (£6,874 tax) and at 40% on £17,525 (£7,010 tax). The total income tax liability here is £13,884. If this individual makes a pension contribution of £17,525, their total income tax would be reduced by £7,010, or 40% of their contribution, to £6,874.
50% taxpayers should maximise pension contributions before 6 April
Tax relief on pension contributions is given at the marginal rate of tax paid by the individual paying the contribution.
This means that, for instance, someone earning £25,000 will receive 20% tax relief on a contribution of £2,500; someone earning £50,000 will receive 40% tax relief on a contribution of £5,000. Someone earning £200,000 will receive 50% tax relief on a contribution of £40,000.
In practice this means the £40,000 pension contribution has only cost them £20,000, with basic rate tax relief recovered immediately at 20% and a further 30%, or £12,000, reclaimed via self-assessment.
From 6 April 2013 the 50% additional rate of tax falls to 45%. This will reduce the extra tax relief available to people earning £150,000 or more.
This means that a 45% taxpayer will receive up to £2,500 less in tax relief on a £50,000 pension contribution than they would when they were a 50% taxpayer. It therefore makes sense to maximise pension contributions before the tax year end to benefit from the more generous level of tax relief and thereby also reduce total income tax liability.
Make sure flexible drawdown is used in a tax-efficient way
Flexible drawdown allows a person to take unlimited amounts out of their pension scheme. In order to be eligible for flexible drawdown you must satisfy a secure minimum income requirement (MIR) of £20,000 a year.
All flexible drawdown payments are taxed as income in the same way as other pension payments and withdrawn money could also be liable to other taxes.
Moving large sums out of the tax-relieved environment of a SIPP – in which not only are contributions tax-free, but there is no CGT or IHT on death benefit lump sums – opens up the possibility incurring all sorts of unanticipated tax liabilities.
To minimise these potential liabilities individuals might want to keep flexible drawdown withdrawals within the basic rate income tax threshold of 20%, rather than risk paying up to 50% on larger amounts.
People should also remember that any money moved into drawdown immediately becomes liable to tax at 55% on the death of the individual. Withdrawing money in annual tranches, rather than in one go, will minimise the amount exposed to this charge.
Billy Mackay is marketing director at AJ Bell
This feature was written for our sister website Money Observer
Like a self-select ISA but for pensions, self-invested personal pension is a registered pension plan that gives you a flexible and tax-efficient method of preparing for your retirement. It gives you all sorts of options on how you put money in, how you invest it and how it’s paid out and offers a greater number of investment opportunities than if the fund was managed by a pension company. SIPPs are very flexible and allow investments such as quoted and unquoted shares, investment funds, cash deposits, commercial property and intangible property (i.e. copyrights, royalties, patents or carbon offsets). Not permitted are loans to members or people or companies connected to the SIPP holder, tangible moveable property (with the exception of tradable gold) and residential property.