Pension planning should be an important component of all tax and savings strategies for anyone aged under 75.
Tax Advantages Of Pension Schemes
There are significant tax advantages – most notably for higher or additional rate tax payers – for people contributing to pension schemes in the form of tax relief, but these have to considered along with the restrictions on when and how benefits can be drawn.
Tax Relief On Pension Contributions for Higher and Additional Rate Taxpayers
Making pension payments up to the amount of the contributor’s income that is subject to higher and additional rate tax will maximise the benefit.
Higher Rate Taxpayers
Higher rate taxpayers who make a pension contribution save tax at 42.5% on the basis that their basic rate tax band is extended so that it covers their dividend income. The saving consists of the 22.5% difference between the higher and basic tax rates on dividend income and the 20% basic rate tax relief deducted from the pension payment.
Additional Rate Taxpayer
The saving for an additional rate taxpayer in a similar situation could be 47.5%, i.e. 27.5% plus 20%, if exceptionally the pension contribution were to result in dividend income being taxed at the basic rate instead of the dividend additional rate, which is highly unlikely. A similar result can be achieved by claiming other reliefs that reduce taxable earnings.
Pensions Contributions and Dividends
Pension contributions which have the effect of removing dividends from the higher rate tax bracket can produce tax relief at an effective rate of 42.5%.
Pension Contributions and Capital Gains Tax
Pension contributions may also impact on Capital Gains Tax liabilities because they will increase a person’s basic rate tax band and, therefore, reduce the amount of gains taxed at the higher CGT rate of 28%.
Pension Contributions and National Insurance Contributions
Employers’ contributions and pension benefits are not subject to NIC.
Tax On Pension Funds
The tax position of the pension fund is essentially the same as the tax position of NISAs and offshore bonds. The differences lie in the tax treatment of the initial investment and the encashment proceeds of these various plans.
Where a person makes pension contributions net of tax at 20%, it is the grossed-up payment that should not exceed the income that is subject to higher or additional rate tax. This is called the Annual Allowance and is currently £40,000.
Pensions Contributions For Non-Earners
It is possible to contribute up to £3,600 gross a year to a registered pension for a partner or children with little or no earnings. Where this is the case, contributions benefit from tax relief at 20% even if the individuals themselves do not actually pay any tax.