The tax rate applied to the first £12,500 of income earnt in a tax year is 0%. This is what is known as the personal allowance, however not everyone benefits from it because it is reduced by £1 for every £2 of taxable income earnt in excess of £100,000. This means that if you have taxable earnings in excess of £125,000 your personal allowance is removed completely.
Personal pension contributions act to extend the basic rate tax band and therefore allows those able to make a gross contribution equal to the amount of income earnt in excess of £100,000, to regain the allowance in full. An example of how pension contributions can help clients in this situation is as follows:
- Client A has employed income of £95,000, taxable benefits of £2,500 and received a bonus of £30,000. There taxable earnings are therefore £127,500.
- If no pension contributions are made, then their income tax liabilities would be £43,500 and total take home pay would be £75,140 after accounting for NI contributions.
- If a gross contribution of £27,500 were made Client A would need to transfer £22,000 of their savings to a pension. Basic rate tax relief is given at source which means the investment is uplifted to £27,500. Client A would claim higher rate relief via self-assessment totalling £5,500 (20%) would regain 100% of their personal allowance, creating an additional saving of £5,000.
- The net cost of the contribution above is £11,500. Without accounting for investment growth, this contribution amounts to a minimum of £27,500 sat in a pension for future benefit. The effective rate of relief is in excess of 58%.
This is a clear example of how allowances can be utilised effectively when knowledge is applied. For more information on this, tax year end planning or financial planning more generally, please contact us.
Note – the figures in this article relate to the 2020/21 tax year.
The personal allowance is increasing to £12,570 for 2021/22.
The Financial Conduct Authority does not regulate tax advice.