Pension Contributions and CGT

With the massive Government debt that has arisen as a result of the financial support measures introduced in response to the coronavirus pandemic, pension tax relief could be seen to be low hanging fruit to reduce the financial deficit.

Whilst there is no certainty of change, there is speculation – particularly in the National Press.

Contributions to registered pension plans are highly tax efficient. Indeed, they are so tax efficient that the tax reliefs will inevitably remain under Government scrutiny and so, even if there are no changes in the March 2021 Budget, changes cannot be ruled out in the future.

Not only will they give tax relief on contributions (at the individual’s 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 people. As we know, basic rate tax relief is given at source so that 20% tax at source is deducted from 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.

As mentioned above, it has been fairly well publicised that the current tax reliefs under personal pensions are under threat. The reliefs currently available may not be available in the future. What is not so readily appreciated is that because of the way relief is given, contributions to personal pension plans can indirectly provide other tax advantages.

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 2020/21) 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 £50,000). Higher rates of CGT apply where the capital gain arises on residential property (please see below).

For such people, it can therefore pay for them to maximise the amount of the basic rate tax band available. Making contributions to a personal pension plan can facilitate this.

Example

Joe has earned income of £32,000 in tax year 2020/21. The basic rate threshold for this year is £50,000 (including the personal allowance of £12,500).

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 2020/21. As things stand his CGT bill will therefore be:

This CGT bill will be payable on 31 January 2022 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.

For income tax purposes, this will increase his basic rate tax band from £37,500 to £41,500 (and his basic rate threshold from £50,000 to £54,000). This now means that all of the taxable capital gain is taxed at 10% meaning he saves tax of £400.

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 2022. 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.

And remember, for disposals on or after 6 April 2020, individuals and trustees are required to use the online service to inform HMRC of any gain and pay any CGT due within 30 days of completion – 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 30 days. These rules affect landlords, property developers or UK residents who sell a residential property that is not their primary home.

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

And, of course, should there be some announcement from the Chancellor on CGT, possibly in the 3 March 2021 Budget, pension contributions could provide even more valuable relief. The Chancellor asked the Office of Tax Simplification (OTS), in July 2020, to carry out a review of CGT, to ‘identify opportunities relating to administrative and technical issues as well as areas where the present rules can distort behaviour or do not meet their policy intent’. Based on the first report published by the OTS on 11 November, the Government might look to introduce proposals, such as taxing capital gains at the same rates as income and reducing the annual exempt amount.

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Sources: Techlink