Reducing tax with a pension contribution

Paying money into a pension can be a great way to reduce your income tax liability.

But more and more people are looking at other investments for their savings including VCTs.

A pension qualifies for tax relief at your highest marginal rate. Effectively any money you pay into a pension will avoid the tax it would have paid, at the highest rate you would have paid on it.

As an example. Mr White earns £60,270 per year, making him a 40% tax payer. His earnings are taxed as follows:

0%	on the first £12,570 =£0
20%	£12,571 to £50,270 = £7,536
40%	£50,271 to £60,270 = £4,000

This means he has a total income tax bill of £11,536.

If he pays £10,000 into a pension, he gets 40p in every £1 removed from his income tax bill. So, rather than have £6,000 in his pocket, he has £10,000 in a pension.

Advantages of pension contribution

It reduces your income tax liability
You can choose the level of risk you want to take with the underlying investments
When you take benefits you can take up to 25% of the fund tax-free (in most cases)
The fund value is usually not counted for inheritance tax
Employers usually pay into a pension for you too

Want to start saving tax today? Unsure if a pension contribution is the best option for you?

Pension contributions - tax avoided or tax deferred?

One of the big problems with paying into a pension is that it might just be a way of delaying paying tax.

It may even result in you paying more tax!

You might avoid tax when the money is paid in, but when you take it out again it would be subject to income tax (except for the 25% tax free).

Whilst he was working, Mr Brown was a higher rate tax payer. He decided to pay £10,000 into a pension, and in doing so saves £4,000 in tax.

So he has £10,000 in a pension.

At 55, when he the £10,000 out, because he still has other income of £60,000, this £10,000 is added to the £60,000.

This £10,000 pension withdrawal is taxed as follows:

£2,500 paid tax free
£7,500 subject to tax at 40% (equates £3,000 worth of tax)

This leaves him with £4,500 after this tax. If we add this to the £2,500 he received tax free he is left with £7,000. So, after tax the £10,000 becomes £7,000.

So, although he saved £4,000 in tax when he paid in the £10,000, he has lost £3,000 in tax when it came out.

So, it only saved his £1,000 in income tax, or 10% in other words.

The tax savings on a pension would work better when you pay a higher rate of tax when you make the contribution, but take it out when you pay a lower rate of tax. Again an example might help:

If Mr Brown took the £10,000 out of his pension at age 65, and his income at this point was £20,000 per year.

The £10,000 he receives is taxed as follows:

£2,500 paid tax free
£7,500 taxed at 20% leaving him with a total of £8,500.

So, he avoided £4,000 when he paid in the money, but only paid £1,500 when it came out. So in effect had a £2,500 tax saving.

Paying more tax with a pension contribution

It is possible that a pension contribution and later withdrawal could mean you pay more tax. This is perhaps more likely for professionals such a solicitors who start out their career with lower earnings and eventually have much larger income.

Gabe, is a trainee solicitor. At age 30, he earns £30,000 per year.

He pays £10,000 into a pension, he saves £2,000 in income tax on this payment, and has £10,000 in a pension, rather than £8,000 paid to him.

He’s successful in his career, and eventually retires. When he retires, he is a higher rate tax payer meaning…

When he takes £10,000 from his pension at 65, £2,500 is tax free, and £7,500 is taxed at 40% leaving him a total £7,000 after tax.

He saved £2,000 when he paid the initial £10,000 into a pension, but he has paid £3,000 in tax when he took it out!

So, the pension contribution means he paid more in income tax rather than make a tax saving.

This is perhaps a more unusual situation. And it completely ignores investment growth (over what would be a very long time in this example). It also ignores potential savings on National Insurance too. But

However, it is a potential situation for someone who is a basic rate tax payer when they make a pension contribution, but a higher rate tax payer when they make the withdrawal.

Company Directors/Owners and Pensions

It is possible for a company director/owner to use a pension to take money out of their business and avoid both corporation tax, and an immediate income tax charge.

A pension contribution paid by an employer (the business) is not subject to corporation tax, provided it is a legitimate business expense under the “wholly and exclusively”.

There is no income tax to pay on the contribution for the employee for whom the pension payment is paid, not until he takes out the money.

If you are relatively young and some way off retirement age, and feel that you may need access to the funds, then a VCT may be a better way of taking money out of your business.

If you want advice on how to reduce your tax, or have a question, or just want to have a chat about reducing you tax liability with a UK Qualified Independent Financial Adviser, then phone now on 01793 686393 or contact us online.