Andy James looks at how clients can make pension contributions in the most tax efficient way
Pensions are used by most individuals as an efficient method of saving money towards their retirement as they offer access to tax free cash and taxable income.
While it makes little sense to tie money up in pensions if they are unlikely to be required as a retirement pot, if funding a pension is a sensible option, then it also makes sense to get the optimum benefits out of making the contributions.
There are various areas for advisers to consider when it comes to the most opportune times for clients to make contributions. Firstly, for those with a level of flexibility in their earnings from one year to the next should set their contributions against higher and additional rate tax.
This sounds simple and to many it will be but people shouldn’t get trapped into making regular monthly contributions if they are unsure what earnings will be at the start of any year.
Far better to make one off payments towards the end of the tax year when they will have a better idea of what their income will be and how much they could pay into pensions and claim the higher levels of tax relief. It’s important not to miss the deadline for tax year contributions.
Playing catch up
With carry forward available it is possible to play ‘catch up’ if for one or more years the earnings are insufficient to warrant making pension payments.
Clients can utilise any unused allowances from the previous three tax years, so with the current year’s allowance also the total contribution could be up to £200,000 if they suddenly have a bumper year where income is in excess of this level.
While the annual allowance will drop to £40,000 in the next tax year, the current £50,000 allowance will still be available for carry forward for the next year or two so no reason to panic at this time.
If needs be, there is also the possibility of amending the pension input period so that contributions can be made in the current tax year but not tested against the annual allowance until the following tax year. That would increase the maximum potential contribution to £240,000 in this tax year.
For those who are in danger of losing their child benefit because their income is in excess of £50,000, pension contributions can have a sizable benefit.
The loss of child benefit runs at 1% of the benefit for every £100 of income in excess of the £50,000 limit so will be totally lost once £60,000 is received. For someone on say £60,000 making a gross pension contribution of £10,000 would ensure that their net income was returned to the maximum level of £50,000.
The cost, allowing for tax relief at 40%, would be £6,000 but the benefit would be far greater as all the child benefit payments would also now be received.
With child benefit amounting to £1,055 a year for the first child, and £696 for each subsequent one, you can see that someone on this level of income with a few children would find pension contributions compelling.
The next major consideration for pension payments is when income reaches £100,000 and clients start to lose their personal allowance. The allowance reduces by £1 for every £2 of income above the £100,000 level. The current personal allowance is £9,440 and will be completely lost when they have income above £118,880.
This means they are effectively paying tax at 60% on income between £100,000 and £118,880. Using pension contributions to reduce the income to below the £100,000 level and regain the personal allowance will give the equivalent of 60% tax relief on pension contributions between these points.
One point of caution with any pension planning, don’t forget that pensions cannot be accessed under normal circumstances until the age of 55 and then the lump sum will be limited to 25% of the total.
It is therefore important to make sure that cashflow and access to liquid capital is not unduly affected by any planning that is done. So people should always make sure that they have sufficient amounts put aside for the unexpected before making any plans to save tax and other benefits. As noted above, ‘catch up’ can always be played later if necessary.
Andy James is advice policy manager at Towry
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