Making pension contributions to reduce Capital Gains Tax

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Contributions to registered pension plans are highly tax efficient.

Not only will they give you tax relief on contributions (at your top rate(s) of tax on income) but contributions are then invested in a fund that is free of tax on investment income and capital gains and a part of the benefits can be drawn in the form of tax free cash.

However, the payment of pension contributions can confer other tax planning benefits for people in certain circumstances.

One of these is due to the way that higher rate tax relief is given on payments to personal pension plans by certain individuals. Basic rate tax relief is given at source so that 20% tax at source is added to any pension contribution paid to the provider. Higher rate tax relief is given by increasing the individual’s basic rate tax band. This means more of the individual’s income falls within basic rate rather than higher rate tax.

Because of the way relief is given, contributions to personal pension plans can indirectly provide other tax advantages. For example, please see Making pension contributions to reclaim the personal allowance.

A tax saving can also be made in relation to capital gains tax (CGT). For example, people who sell assets and realise a capital gain will find that to the extent that any taxable capital gain is not covered by the individual’s available annual exemption (£12,300 in 2022/23) the gain will be taxed at 10% (to the extent that it falls within their basic rate tax band) and 20% (to the extent that it exceeds the basic rate threshold of £50,270). Higher, 18% and 28%, rates of CGT apply where the capital gain arises on residential property (please see below). For such people, it can therefore pay them to maximise the amount of the basic rate tax band available. Making contributions to a personal pension plan can facilitate this.

Provided the individual has sufficient relevant UK earnings, a net contribution to a personal pension plan will increase their basic rate tax band, potentially allowing some or all of a taxable capital gain to be taxed at 10% instead of 20% (or 18% instead of 28% in the case of a residential property gain).

Example – Joe

Joe has earned income of £32,270 in tax year 2022/23. The basic rate threshold for this year is £50,270 (including the personal allowance of £12,570).

Joe has realised some shares in his employer company (that he acquired under an approved profit sharing scheme) for £64,300. He plans to use the proceeds to help buy a caravan for £55,000, so has about £9,000 free for other use. He paid £30,000 for the shares, so his taxable capital gain is therefore £34,300. From this he can deduct his annual exemption of £12,300, leaving £22,000 taxable in 2022/23. As things stand his CGT bill will therefore be:

Income £12,570 @ 0% = £Nil
Income £19,700 @ 20% = £3,940
Capital gain £18,000 @ 10% = £1,800
Basic rate threshold £50,270
Capital gain £4,000 @ 20% = £800
______
Total £6,540
Less: income tax paid (£3,940)
CGT due £2,600

This CGT bill will be payable on 31 January 2024 and eat into the £9,000 in cash he has available after purchase of the caravan.

To reduce this tax bill Joe could consider making a net contribution of £3,200 to a personal pension plan (£4,000 gross).

For income tax purposes, this will increase his basic rate tax band from £37,700 to £41,700 (and his basic rate threshold from £50,270 to £54,270). This now means that all of the taxable capital gain is taxed at 10% meaning he saves tax of £400.

Income £12,570 @ 0% = £Nil
Income £19,700 @ 20% = £3,940
Capital gain £22,000 @ 10% = £2,200
Basic rate threshold £54,270
______
Total £6,140
Less: income tax paid (£3,940)
CGT due £2,200

So, out of the £9,000 of cash after purchase of the caravan, Joe will use:

  • £3,200 to make a contribution to a personal pension plan; and
  • earmark £2,200 for payment of the new reduced CGT bill on 31 January 2024.

He could perhaps put the balance of £3,600 towards annual service charges on the caravan.

Note that the same result can also be achieved where a gross pension contribution reduces taxable income to below the basic rate tax threshold, e.g. an occupational pension contribution deducted from salary before tax, or an AVC to an occupational pension scheme. The tax saving is achieved through the resulting increase in the amount of the basic rate tax band available to the capital gain.

Many people who realise capital gains these days may be buy-to-let investors. For this set of people, the CGT regime is harsher with capital gains being taxed at 18% (if within the basic rate tax band) and 28% if over the basic rate threshold.

It should also be borne in mind that a return in respect of the disposal of a residential property (e.g. a buy-to-let property) has to be delivered to HMRC within 60 days following the completion of the disposal, and a payment on account has to be made at the same time, for disposals completed on or after 27 October 2021; the time limit is 30 days if the completion date was between 6 April 2020 and 26 October 2021 – please see HMRC’s guidance. Penalties will be applied for any late filing and the guidance makes it clear that interest will accrue on the outstanding tax if it is still unpaid after 60/30 days. These rules affect landlords, property developers or UK residents who sell a residential property that is not their primary home.

For such Clients, planning using pension contributions could be even more useful – and important – provided, of course, they have sufficient relevant UK earnings.

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

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Sources: Techlink

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