It is possible to reduce this year’s income tax bill and claim free money for your pension, in what is a win-win solution for millions of workers. HM Revenue & Customs is the only loser here so this option is worth considering.
In his budget last year, Sunak froze income tax thresholds for five years.
The 20 per cent basic personal allowance, at which people start paying income tax, will be frozen at £12,570 until at least tax year 2025/26. The 40% higher rate allowance will remain at £50,270.
As wages rise, more workers will be drawn into HMRC’s net, says Adrian Lowery, personal finance expert at investment platform Bestinvest.
“If a pay rise takes your salary above £12,570, you will go from zero income tax to 20% on the amount above that level.”
Likewise, if your salary exceeds £50,270 at any time during the five-year freeze, you will start paying tax at the top rate of 40% on anything over that figure.
Sunak’s stealth raid is a tax hike in all but name, but he hopes we don’t notice. Yet there is a way to fight back – and increase your retirement pool at the same time.
By putting more money into a pension, you can request a tax reduction on your contributions. The higher your tax bracket, the more you can get.
Lowery says, “Personal pension contributions attract tax relief at your marginal income tax rate, so paying a pension is a good way to protect your wealth from income tax.”
This works both for the self-employed contributing to a personal pension, and for employees benefiting from a company pension, where their employer offers a “salary sacrifice” formula, he adds.
“This is where you take a pay cut or forego a bonus in favor of a pension contribution instead. In doing so, it is possible for those earning just above a tax threshold remove a tax bracket.
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A basic tax relief of 20% is automatically applied to pension contributions, says Kevin Sefton, managing director of personal tax app Untied.
“If you put £80 into your pension, the government will add another £20, so a total of £100 will go into your pension kitty.”
If you pay 40% tax, you can claim a refund of the additional 20% relief via your self-assessment tax return.
This means that every £100 of pension will in practice only cost £60 to a higher rate taxpayer. For wealthy taxpayers at the additional 45% rate, £100 pension will cost them just £55.
It’s an incredible advantage and most people should make the most of it, especially as Sunak hits us with tax hikes left, right and center.
Retirement contributions have other tax advantages, as your funds can grow tax-free until you start withdrawing money from age 55 or later.
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The funds you have left after your death are exempt from inheritance tax, which is not the case for other savings and investments, such as Isas.
Sefton says you can claim tax relief on anything up to 100% of your annual earnings, provided you don’t exceed the annual allowance of £40,000 a year.
Below postponement of pensions rules, you can offset any unused allowance from the previous three tax years, provided you were a member of a registered pension plan during that time.
The tax break for pensions is extremely valuable, but there are constant rumors that the cash-strapped Treasury will reduce this benefit. It gave savers a huge £41.3billion tax break in the 2019/20 tax year, so Sunak has a real incentive to cut that amount.
“It pays to make the most of pension tax relief while you can,” Sefton adds.
Today taxpayers win but HMRC loses. This may not always be the case.