Pensions contributions as higher rate and CGT reducers
Sam Newton, technical project manager Canada Life, shows how pensions contributions can be used to reduce higher rate and capital gains tax liabilities, using four examples to illustrate the points
Pension planning can invariably focus on the decumulation side of retirement, yet for other clients, the accumulation side can be as equally important.
Pension contributions have the obvious effect of building up benefits in retirement and have generous tax reliefs that go hand-in-hand with them. They can also be a useful means of mitigating tax payable on other investments, regaining means tested benefits or for very high earners, a way of regaining their personal allowance, which is lost for those clients with earnings in excess of £100,000.
Using tax relief at source
There are three types of tax relief available to clients; relief at source, net pay arrangements and through tax return, with the vast majority of individual pension arrangements operating the ‘relief at source’ method. This works by giving 20% relief on the contribution and then shifting the tax bands (that is, the basic and higher rates) by the size of the gross contribution. Therefore, a client can push all their earnings into the basic rate band for income tax purposes.
So, for example, if a client was earning £80,000, they would be paying higher rate tax on £37,615. If a net pension contribution of £30,092 was made then this would be grossed up to £37,615 which would then increase their basic rate band by this gross amount. The result is that their entire £80,000 salary would be covered by their personal allowance and extended basic rate band thereby paying no higher rate tax on any of their earnings.
The diagram below illustrates this in more detail, where the first bar shows the current tax bands and the second bar shows the effect on those bands when a pension contribution is made.
So if more of their income falls into the extended basic rate band, in this example, this means they will no longer pay any higher rates of tax. The knock-on effect of these tax bands shifting can mean that the tax due on other investments may be affected, reducing a client’s tax bill further. It may also result in a client regaining valuable means tested benefits or regaining back certain tax allowances.
Offsetting tax liabilities on investment bonds
Pension contributions can be timed so that they are made in the same tax year as the encashment of an onshore investment bond, where the bond is showing a gain. By using the pension contribution to move a client’s total income into the basic rate band for income tax, including the value of any top slice gain from the bond, further income tax payable on the bond can be avoided.
David has earnings of £50,000 from employment and decides that he wants to surrender his onshore investment bond. After 10 years, his bond is showing a gain of £60,000 where the top slice is £6,000. By making a gross pension contribution of £13,615, he is able to surrender the bond without paying any higher rate tax on it as well as building up his pension fund.
Offsetting CGT on collectives (Unit Trusts/OEICs)
A pension contribution which reduces a client’s overall income into the basic rate band can also be used to mitigate capital gains tax (that is, from the higher rate of 28% to the lower rate of 18%) on part or all of the gain on an investment.
John has a Unit Trust portfolio and decides to cash in part of it. The gain on the part that he encashes is £5,000 in excess of the annual exemption. As his current salary is £45,000 any capital gains tax payable on the funds will all be at the 28% CGT rate.
By making a net pension contribution of £6,092, John will have a grossed up pension contribution of £7,615. This will have the effect of moving all of his income into the basic rate tax threshold and therefore only being liable to CGT at 18% instead of 28%. The result is a saving of £500 in CGT and £1,046 in income tax.
Means tested benefits
Means tested benefits can also be affected by the level of earnings and a pension contribution can reduce those earnings down therefore regaining entitlement to those benefits.
Child benefit is a means tested benefit and for those with adjusted net earnings over £50,000, 1% of their child benefit is lost for each £100 over £50,000. This results in a client completely losing their entitlement to child benefit where adjusted net earnings are over £60,000.
By making a pension contribution they can reduce their overall adjusted net income and regain part or all of their entitlement to child benefit.
James is married with three children and earns £58,000 a year from his job and is due to receive a bonus of £5,000. His wife has chosen to be a homemaker and does not currently receive an income from employment.
As James’s income is over £60,000 he has lost his entitlement to child benefit, which would have been, £1,076.40 for his first child and £712.40 each for his other two children, giving a total tax charge of £2,501.20
If James was to make a pension contribution for £13,000, it would bring his adjusted net income down to £50,000, which would mean he would regain entitlement to the full child benefit for his three children.
Obviously, the client will need to weigh up their net income after any tax charge or pension contribution to see if it’s beneficial to them. However the pension contribution has provided an effective rate of tax relief of 59% on the pension contribution.
For those clients fortunate enough to have earnings in excess of £100,000, their personal allowance will be lost at a rate of £1 for every £2 over £100,000. Again, by making a pension contribution, it is possible to regain part of all of the personal allowance.
Farah has earnings of £121,200 a year as the director of a marketing agency and has no personal allowance. She decides to make a pension contribution of £21,200 bringing net adjusted earnings down to £100,000 and regaining her personal allowance and effectively getting 60% tax relief on the pension contribution.
The difference in tax paid is £12,720, which equates to an effective rate of 60%. In addition she has increased her basic rate band (the basic rate threshold) by the amount of the gross contribution.
Making pension contributions can be a useful tool for not only building a large pension pot in retirement but also for mitigating tax in other areas and a holistic approach should be taken which considers the client’s wider financial objectives to see if the decision to make a pension contribution can help the client to mitigate tax in another area of their financial planning needs.
Visit the Canada Life website