How using a pension can claw back losses from higher rate income tax

Middle-class families who have been caught out by the freeze in income tax thresholds could save hundreds of pounds by boosting their pensions.

The number of Britons paying the higher rate of income tax will soar from four million to five million by 2026, following Rishi Sunak’s Budget.

The higher 40 per cent rate will be frozen at £50,270 from April 2021 until 2025/26 — by which point one in six taxpayers will have been dragged into this band, as earnings rise with inflation.

But households can save for their future and avoid rocketing tax bills by squirrelling away more cash. 

This is possible because pension contributions are subject to tax relief at the same rate you pay income tax.

It means savers can effectively wipe out any higher-rate tax bills on earnings above the threshold by saving anything above £50,270 into their pension.

So every £100 of earnings over the higher rate threshold would be worth £60 if taken as income now, or remain at £100 if saved into a pension.

Rebecca O’Connor, of Interactive Investor, says: ‘If you are happy to defer some of your current income by putting it in a pension and taking it later instead, you could end up paying a lot less tax over time.’

Salary sacrifice schemes mean you divert some of your income to your pension before tax is paid, and may mean you can stay in a lower tax bracket if your pension contributions take your income below the threshold again.

Under the Chancellor’s income tax freeze, someone now earning £49,000 whose pay rises by 3 per cent every year will see their annual tax bill rise by £3,128 by 2026.

But if they put £500 into their pension every month over those five years, their bill would be just an extra £609. This is despite them earning an extra £7,804 a year by the end of the freeze.

It also works for those likely to be pushed into the 20 per cent basic rate band. This threshold will be frozen at £12,570.

Someone earning £11,500 whose pay rises by 3 per cent a year will start paying income tax three years into the personal allowance freeze.

By the end of the freeze they would be paying an extra £364 a year in tax without pension contributions. 

But if they put £50 a month into their pension, they would only pay £172 a year more in tax, Hargreaves Lansdown has worked out.

Check your employer offers salary sacrifice, but there are other ways to cut tax bills via your pension.

Anyone can invest into their pension post-tax and claim it back. The taxman automatically adds relief to contributions at the basic 20 per cent rate. So if you put £8,000 in your pension, the Government will add an extra £2,000.

Higher and top-rate taxpayers putting money into pensions can claim their additional 20 or 25 per cent relief through annual self-assessment returns.

This is particularly advantageous for higher earners who will get relief at their marginal rate of 40 or 45 per cent now, but may only get basic rate relief when they retire. Only a minority of pensioners have retirement income that puts them into the higher tax bands.

You can only get tax relief on pension savings up to £40,000 per tax year, but you can pay in unused allowances from the previous three years.

More than a million savers are also expected to hit the pensions Lifetime Allowance (LTA) threshold by the time they retire, after the Chancellor froze it at £1,073,100, according to Royal London.

Pensioners will pay a 55 per cent tax charge if they withdraw anything above this limit as a lump sum. If taken as income, it will be charged at 25 per cent. This will raise an additional £1 billion.

Savers could maximise their Isa allowance instead to avoid breaching the LTA. Isa investments up to £20,000 a year are tax free. 

The ‘small pots’ rule allows you to make tax-free withdrawals if your pension is made up of multiple pots and some are worth less than £10,000.

You can also pass money to your partner or children who may have smaller pension pots.

Richard Harwood, of wealth manager Brewin Dolphin, says savers shouldn’t be too worried about breaching the LTA.

He adds: ‘Savers must remember that it is only the money in excess of the LTA that becomes subject to extra tax.

‘A good adviser will be able to work out a plan to create an effective drawdown strategy, in a tax-efficient way.’

Meanwhile, the limit at which an estate qualifies for death duty will stay at £325,000 until 2026. But private pensions can be passed down outside of your estate tax free if you die before the age of 75. The beneficiary will pay tax at their marginal rate of income tax thereafter.

Passing on investments, cash and property is also free of inheritance tax if it takes place seven years before death.

The capital gains tax threshold was frozen at £12,300, although further reform is expected.

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