2020 was a year in which many people had to, for many different reasons, revisit their finances and where the value of seeking financial advice came to the fore.
With tax year-end now on the horizon, some clients may find themselves in the fortunate position of having extra income, or perhaps in receipt of a redundancy payment, or they may be holding cash because of investment uncertainty. If so, using that money to make a pension contribution could not only boost the value of their funds but also save on tax.
In a nutshell when a client is looking to make a personal pension contribution, or if a third party pays a contribution for your client, then from a tax relief point of view, relevant income is key.
The maximum these contributions can be in order to obtain tax relief, which applies up to your client’s 75th birthday, are 100% of your relevant income or £3,600, whichever is the highest.
You also have to consider employer contributions, which are not limited to earnings, and the annual allowance.
For ease in the examples below we’ll focus on tax relief, assume there are no employer contributions and that any contributions are below the available annual allowance and carry forward limits.
What are relevant earnings?
The pensions tax manual PTM044100 details all the sources of relevant income. The main ones that you are likely to see are;
- Employment income – which includes salary, bonus, overtime, commission or the part of a redundancy payment above the £30,000 tax exempt threshold
- Taxable benefits in kind (for employees earning over £8,500, and directors)
- Statutory Sick Pay (SSP) and Statutory Maternity Pay (SMP) paid by the employer
- Permanent Health Insurance (PHI) payments paid by the employer whilst you are still in employment
- Self-employed income
- Income from a UK and/or EEA furnished holiday lettings business
But for most clients, their relevant earnings are likely to be their pay from employment or self-employment.
It’s sometimes easier to think about what aren’t relevant earnings, even though these are subject to income tax. This includes things such as pension income, dividends and most rental income as well as investment bond gains.
If your client only has relevant earnings
If your client’s earnings are below £3,600 they can put £3,600 into their pension, and if their earnings are above that they can effectively put in as much as they earn. For many people putting their whole salary into a pension isn’t possible with bills and living cost to pay. However, should your client have capital elsewhere, could this be better deployed through investing in a pension?
The advantages of tax relief on pension contributions could, for example, turn £8,000 sitting in an ISA into £8,500 in your client’s bank account. If the client is a basic rate taxpayer and they put the £8,000 into a pension, it would be worth £10,000 after the £2,000 relief at source is added. They could then take £2,500 of this tax-free and the remaining £7,500 would be taxed at 20% means £1,500 is taken from the £10,000.
By diverting the money into pensions you can not only boost your client’s funds but, they may also pay less in tax. Of course, access requirements must be considered due to minimum pension age and the possibility of triggering the money purchase annual allowance etc.
A client could even make themselves effectively a non-taxpayer by using capital in this manner. Or perhaps have one last bite at the tax relief cherry before retiring by using capital.
And if there are non-relevant earnings, can they get tax relief on these?
While on the surface it may appear that you can’t, by using the tax relief available from relevant earnings there can be a knock-on effect on the non-relevant earnings taxation.
A simple example of this being a low salary high dividend model that many limited company owners use. Taking a salary of £10,000 and dividends of £50,000 means that (based on UK rates) £10,000 of dividends are in the higher rate tax band. Dividends are taxed (after the £2,000 zero rate of taxation) at 7.5% in the basic rate and 32.5% in the higher rate. The client is, therefore, paying 25% more for dividends in the higher rate.
Paying £8,000 into a relief at source (RAS) pension scheme (£10,000 gross) means that the client expands their basic rate band by £10,000. Putting all their dividends within the basic rate, saves £2,500 in their tax return (25% being the difference in taxation of dividends between the basic and higher rate). In total for the £10,000 in a pension you get 45% tax relief (£2,500 off their tax bill plus £2,000 RAS, £4,500 tax saved on a £10,000 pension contribution).
Many business owners would probably be better off taking less in dividends and making an employer pension contribution, but the above example illustrates the numbers and the principle.
This same principle can be the case for other forms of taxation. Perhaps your client has buy to let income taking them into a higher tax band, or, are they in a tax trap (child benefit, personal allowance etc.). If so, making a pension contribution could produce some higher rates of return than you expect.
Furthermore, if your client has a capital gain, then moving this into lower tax band has the same effect. With clients who have an investment bond gain, thanks to the top-slicing rules you can get three figures on the tax relief. The calculations can be complex, but good tax modellers can help with the sums.
Mark Devlin is senior technical manager at Prudential