Making pension contributions to reclaim your personal allowance

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Did you know, effective tax relief of 60% or more can be obtained on pension contributions where Clients are able to reclaim their personal allowance?

The threshold for the loss of the personal allowance has remained fixed at £100,000 since its introduction in 2010. Meanwhile, the personal allowance has almost doubled from £6,475 in 2010/11 to £12,570 in tax year 2022/23. This means that both the number of people impacted, and the band at which client’s pay an effective rate of 60% has grown substantially. It is a strange quirk of the tax system to have marginal income tax rates of 20%, 40%, then 60%, then falling back to 40% before finally rising to 45% again once income reaches £150,000.

The 60% effective rate is due to the fact that income in this band is not only taxed at 40%, it also reduces the personal allowance on a 2 for 1 basis. That is for each £2 of additional income above £100,000 the personal allowance reduces by £1. At income levels above £125,140 the personal allowance is zero.

The personal allowance income limit is based on an individual’s adjusted net income. For those familiar with tapered annual allowance calculations, note that this is quite different from the adjusted income figure used there. However, adjusted net income involves the same first step, which is to calculate the individual’s total taxable income or ‘net income’. This includes income such as earnings, profits from self-employment, rental income and dividends and is after deductions for pension contributions made gross, such as occupational pension contributions deducted from salary before tax is calculated, or an AVC paid gross to an occupational scheme.

From the ‘net income’ figure two important deductions are made to arrive at ‘adjusted net income’. These are the grossed up value of any relief at source pension contributions and any charitable donations made by Gift Aid.

Personal contributions to both occupational schemes and personal pensions schemes will therefore reduce the adjusted net income figure and so can restore some or all of the personal allowance.

Making personal pension contributions, example

Keith has income of £125,140 in 2022/23. He makes a net (relief at source) pension contribution of £20,112 on April 2022 and receives £5,028 tax relief at source. His net income falls by £10,056 in return for a pension contribution of £25,140 – an effective rate of tax relief of 60%.

No pension Personal pension contribution
Income £125,140 £125,140
Personal allowance £0 £12,570
Employee National Insurance* £7,516 £7,516
Tax £42,516 £32,460
Net personal pension contribution £0 £20,112
Net income £75,108 £65,052
Effective tax relief** 60%

*In 2022/23, the primary threshold for Class 1 National Insurance contributions for employees increased from £190 a week (£9,880 a year) from between 6 April 2022 and 5 July 2022 to £242 a week (equivalent to £12,570 annualised) from 6 July 2022 onwards. This means that, for 2022/23, £11,908 of earnings is free of National Insurance for employees. The above National Insurance figure assumes Keith’s salary is received in equal monthly amounts throughout the tax year. If monthly salary payments vary, then the above National Insurance figures might be different.

**Tax saving is £42,516 – £32,460 = £10,056 plus £25,140 x 20% = £5,028. £10,056 plus £5,028 = £15,084, which when divided by the £25,140 pension contribution is 60%.

Salary Sacrifice

Where salary sacrifice is available clients can receive even greater benefits. As well as reducing taxable income, a reduction in salary will also lower both the employee and employer National Insurance contributions. Where the employer is willing to re-invest their National Insurance savings the effective rates of tax can be almost 68%.

If Keith instead was able to make his pension contribution via salary sacrifice, on 6 April 2022, for a net cost of just £9,239 an employer contribution could be made of £28,924. (This assumes the employer also puts their National Insurance saving of £3,784 into Keith’s pension – £25,140 salary sacrificed x 15.05% employer National Insurance = £3,784.) Note that, if the salary was sacrificed part way through the tax year, rather than on 6 April 2022, then the below figures would need to be recalculated accordingly.

No pension Salary sacrifice and employer contribution
Income £125,140 £100,000
Personal allowance £0 £12,570
Employee National Insurance* £7,5162 £6,699
Tax £42,516 £27,432
Net income £75,108 £65,869
Employer contribution £28,924
Effective tax relief** 68.1%

*The National Insurance figure assumes Keith’s salary is received in equal monthly amounts, and that his salary was sacrificed on 6 April 2022. Because the National Insurance primary threshold was increased from £190 a week (£9,880 a year) from between 6 April 2022 and 5 July 2022 to £242 a week (equivalent to £12,570 annualised) from 6 July 2022 onwards, this means that, for 2022/23, £11,908 of earnings is free of National Insurance for employees. If monthly salary payments vary, then the above National Insurance figures might be different.

**Tax and employee National Insurance saving is £42,516 – £27,432 = £15,084 plus £7,516 – £6,699 = £817 = £15,901. Employer National Insurance saving is £3,784. £15,901 + £3,784 = £19,685, which when divided by the £28,924 pension contribution is 68.1%.

If you would like to book a review of your pension contributions ahead of the end of this tax year or beyond, please contact us here.

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Sources: Techlink

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