Pensions

PERSONAL PENSION CONTRIBUTION

Making allowable contributions into a personal pension can provide a significant boost to your retirement savings, something that many of us may not be aware of.

James Hounsell looks at why maximising tax relief on your personal pension contributions really does add up.

James Hounsell
Consultant
16 July 2021
3 Minutes

Making allowable contributions into a personal pension means a boost of 25% to your contribution, and in some circumstances can be as high as 60%. Read on to find out why.

Personal income tax allowances and thresholds are being frozen until 2026. As incomes grow, more people will pay more tax, with the Office for Budget Responsibility estimating 1 million more people will become higher-rate taxpayers, especially as we are seeing signs of inflation pressures coming into parts of the world economy.

For many of us the impact of this will have a huge impact on our ability to save for the future, but by making savings into a pension policy when allowable and affordable, and using the tax privileges we are all offered by HRMC, the effects can be very valuable. Please see the example below.

Case study

Sam is 55 years of age, lives in the UK (except Scotland) and has accumulated pensions valued at £200,000. The objective is simple: to save in a tax-efficient manner for retirement.

In the 2021/22 tax year, Sam has taxable earned income of £95,000 and has a full personal allowance. Income tax will be £25,432, as shown below. For simplicity, National Insurance has been ignored.

Income Tax band Tax rate Tax
£12,570 Personal allowance 0% £0
£37,700 Basic rate 20% £7,540
£44,730 Higher rate 40% £17,892
£95,000     £25,432

If Sam makes a £20,000 net contribution to a personal pension (which uses the relief at source method) the pension scheme will claim £5,000 of basic rate tax relief from HMRC. As well as receiving an immediate uplift of 25%, the basic rate tax band is extended by the amount of the gross contribution, so in this case £25,000. The revised income tax calculations are as follows.

Income Tax band Tax rate Tax
£12,570 Personal allowance 0% £0
£62,700 Basic rate 20% £12,540
£19,730 Higher rate 40% £7,892
£95,000     £20,432

The following year Sam receives a pay rise of £5,000 and a bonus of £25,000, giving total taxable income for the 2022/23 tax year of £125,000. The personal allowance is reduced by £1 for every £2 of income over £100,000 and is therefore near nil at this level of income, meaning a significant increase in the income taxed at 40%.

Income Tax band Tax rate Tax
£70 Personal allowance 0% £0
£37,700 Basic rate 20% £7,540
£87,320 Higher rate 40% £34,892
£125,000     £42,432

In this case, making a personal pension contribution using a net £20,000 of the bonus will lead to an even greater reduction in income tax due, of £10,000. As before, basic rate tax relief of £5,000 will be added to the pension plan. The pension contribution reinstates 100% of the personal allowance and extends the basic rate tax band by £25,000.

Income Tax band Tax rate Tax
£12,570 Personal allowance 0% £0
£62,700 Basic rate 20% £12,540
£49,730 Higher rate 40% £19,892
£125,000     £32,432

Tax relief of £15,000 has been claimed on a contribution of £25,000 giving an effective tax relief rate of 60%.

During the two years Sam has made net pension contributions of £40,000: there were income tax savings of £5,000 in 2021/22 and £10,000 in 2022/23 and these reduced the true cost of the contributions to £25,000. In addition, HMRC added the tax relief of £10,000 to the fund making its value £50,000 (ignoring investment performance and costs).

Within the pension plan, future investment gains and income are exempt from capital gains tax and income tax respectively. The pension plan is also outside of the estate on death and is therefore sheltered from inheritance tax.

Personal pension contributions have to fall within HMRC rules, and as income increases towards and over £100,000, there are many considerations for taxpayers. This is an area where professional advice can certainly be excellent value for money.

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