Clare Moffat, technical manager at Prudential, explains how pension contributions can help mitigate clients' tax liabilities
Individuals often claim that pensions are complex and that they prefer to save in investments which can be accessed before age 55. However, even for those who do not believe in pensions there are quite a few situations where pensions can help mitigate tax. Surely all clients believe in saving on tax?
Reclaiming personal allowance
This is also known as the high earners’ tax trap. When an individual has adjusted net income over £100,000 then for every £2, that individual loses £1 of their personal allowance until they have no allowance left.
Adjusted net income is total taxable income (which includes the full amount of any bond gain – a fact often overlooked) less certain deductions e.g. gift aid donations and gross personal pension contributions.
This makes the effective rate of tax 60% on income between £100,000 and £116,210 (for 2012/13). If adjusted net income is £116,210 all personal allowance is lost.
How do you calculate the contribution required?
1. Identify total income for personal allowance purposes i.e. adjusted net income
2. Calculate excess over £100,000 limit
3. Calculate contribution to reduce adjusted net income to £100,000
4. Make the personal pension contribution in the tax year in which the personal allowance is lost.
(See case study one).
Mitigating bond taxation
When chargeable gains arise on investment bonds they are assessed for income tax purposes. Broadly, the gain is divided by the amount of years the bond has been held to determine the ‘slice’.
The slice is then added to the top of the individual’s income to assess any tax.
For onshore bonds, if the slice is in the basic rate tax band then no further tax is paid. If in the higher rate band 20% is paid, additional rate 30% (25% from 6 April 2013) is paid. The amount of tax on the slice is multiplied by the complete number of plan years the bond is held to get the total tax payable.
The higher and additional rate tax bands are increased, in tandem, by the gross amount of a personal pension contribution.
1. Identify earnings in higher rate tax bands
2. Calculate bond gain ‘slice’
3. Calculate contribution needed to move some or all of slice into lower tax band.
4. Make the personal pension contribution in the tax year in which the bond gain is taxed.
(See case study two).
Mitigating capital gains tax
When a capital gain is calculated it is added to the top of an individual’s income after all other income and any slice on bond gains.
The part of the gain, if any, in the basic rate tax band is taxed at 18% and the balance at 28%.
The individual’s basic rate band is increased by the amount of any grossed up personal pension contribution.
The principles work similarly for pension contributions paid gross as these reduce the taxable income.
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