Taxing times ahead

Recent changes to income tax and National Insurance contributions can have a big effect on how clients pay into their pension. Andrew Tully highlights what effect these changes will have

Gordon Brown grabbed the headlines in last year's budget when he announced a 2% cut in the basic rate of income tax. However, the changes to personal taxation, due to take effect this April, are more far-reaching than they first appear.

Meanwhile lesser publicised changes to National Insurance (NI) will mean that anyone earning above approximately £35,000 will pay more NI.

The changes mean that, from April, the 10% starting rate of income tax will be abolished for earned income and pensions. So the first slice of people's taxable income will be taxed under the basic rate. This means people will have to pay £223 each year more in tax on this first slice. But the basic rate of income tax is to be reduced by 2p in the pound, to give a new rate of 20%.

At the same time, some substantial changes are on the way to NI. From April, the ceiling for paying the standard 11% rate of NI contributions will rise quite sharply - by £3,900 over and above the normal inflation-linked increase. That means that the main NI rate will now apply to income up to £40,040 a year, rather than the £34,840 level for this year. NI will increase further from April 2009 as the thresholds for income tax and NI will merge.

How will these big changes interact?

As the graph (above) shows, those earning £15,000 a year or less are likely to be worse off. By having more of their income taxed at 20%, rather than 10%, they will pay more in tax. For example, someone earning £8,000 will be around £12 per month worse off.

The biggest winners as a result of these changes will be those earning about £35,000 a year, who will be around £32 per month better off. They will save income tax yet pay no more NI. However the rise in the ceiling for the standard 11% NI contribution rate means that those earning about £40,000 a year will gain very little, as they will now pay the higher rate of NI on more of their income.

How are pensions affected?

These changes also affect pensions. Net payments to personal and stakeholder pensions will change from April 2008.

Currently if people want to pay £1000 into their pension, they pay £780 with the government adding £220 in basic rate tax relief. From April they will need to pay £800 as basic rate tax relief will only be £200. This will also affect members of occupational pension schemes. While tax relief is given automatically via net pay arrangements, basic rate taxpayers will still only get 20% tax relief, meaning a reduction in take home pay. Higher rate taxpayers won't be affected as much as they will get an additional 20% tax relief making up to 40% in total.

However, there is a slight change for members of personal and stakeholder plans as only 20% tax relief is added into the pension with 20% being given via the tax return (rather than 22%/18% at present).

A stronger case for salary sacrifice?

With the NI changes imminent, now is the time to reconsider the benefits of salary sacrifice - particularly for those earning between £35,000 and £40,000 a year. Salary sacrifice means taking a pay cut, or giving up bonus payments, in return for an alternative non-cash benefit - such as an employer pension contribution. Because NI is saved on the cash payment given up, the alternative pension contribution can be increased at no cost to the employer or individual. This is most effective where the income sacrificed is below the upper NI threshold, as this gives an 11% NI saving for the individual (compared to 1% on earnings above this level).

Case Study

Bob has a gross salary of £40,000 in 2008/09. The table shows his income with and without salary sacrifice based on the new income tax and NI rates. The example assumes the employer is willing to add their NI saving to the pension contribution.

In summary, by taking a cut in gross salary of slightly over £4,000 a year, Bob maintains the same take home pay and benefits from an increase of over 30% in his pension contribution at no cost to him or his employer.

As the name suggests, salary is being genuinely sacrificed therefore any benefits which are based on salary may be affected, for example a mortgage or credit card. In addition some state benefits are linked to earnings so may be affected.

The tax and NI changes being introduced in April mean that some people will gain a little and some people will lose a little.

The changes are more about simplifying the number of rates and bands than cutting tax bills. Salary and bonus sacrifice can be an extremely attractive route for many employees and employers, and the tax benefits will become even greater for some after April 2008.

There are, however, some pitfalls, and care needs to be taken to ensure that those who opt for salary sacrifice understand it, know how it affects them, and are able to make an informed decision.