One of the most common questions we get asked by our clients is ‘how can I reduce my tax bill?’ A really smart way to reduce the tax you pay now and build a nest egg for the future is to pay money into a pension.
Here we give you a quick overview of the basic rules and reliefs available;
Types of pension schemes
There are broadly two types of pension schemes from which an individual may eventually benefit from:
It is a legal requirement for all employers to provide a workplace pension scheme due to auto-enrolment legislation.
A Personal Pension scheme is a privately funded pension plan but can also be funded by an employer.
What are the tax breaks?
Making a pension contribution allows the member to obtain tax relief on contributions into the scheme and tax-free growth of the fund.
If an employer contributes into the scheme on behalf of an employee, there is, generally no tax charge on the member and the employer will obtain a deduction from their taxable profits reducing corporation tax payable. Making employer contributions to pension schemes of which Owner Managers are members can be a good way to both reduce corporation tax payable and invest for those individuals future.
There are some controls in place to limit the amount of tax relief which is available to the member and the tax-free growth in the fund.
Firstly, there is a lifetime limit which sets the maximum figure for tax-relieved savings in the fund(s), currently the life time limit is £1,073,100.
Secondly, an annual allowance sets the maximum amount which can be invested with tax relief into a pension fund. The allowance applies to the combined contributions of an employee and employer and is currently £40,000 per annum. However, you can carry forward unused allowances from the previous three years, as long as you were a member of a pension scheme during those years.
Any contributions in excess of the £40,000 annual allowance are potentially charged to tax on the individual as their top slice of income.
Relief for individuals’ contributions
An individual is entitled to make contributions and receive tax relief on the higher of £3,600 or 100% of earnings in any given tax year. However, tax relief will be restricted for contributions in excess of the annual allowance.
An individual receives tax relief at the highest rate of income tax that you pay. So a basic rate taxpayer will get 20% tax relief. This means that every pound you pay in becomes £1.25 (because £1.25 taxed at 20 per cent would become £1). Your pension provider will claim this back from HMRC and the additional amount will be paid into your pension fund. Higher rate taxpayers get 40 per cent tax relief and additional rate taxpayers get tax relief at 45 per cent.
The basic 20 per cent tax relief will be added to each contribution automatically, but if you’re a higher or additional rate taxpayer you’ll have to claim back your extra tax relief via your self-assessment tax return.
A more effective route for an employee may be to enter a salary sacrifice arrangement with an employer. The employer will make a gross contribution to the pension provider and the employee’s gross salary is reduced. This will give the employee full income tax relief (by reducing PAYE) but also reducing National Insurance Contributions.
All tax reliefs for pension contributions must be made in the period in which you want to receive the tax relief so it’s really important to think about this well in advance of your period end and seek advice from your professional advisors as to the best strategy for you or your business.
Please get in touch with our team to talk about how you can use pension contributions to offset tax.