How much does a pension contribution really cost you?

Recently we have seen an increase in the number of clients who are suddenly paying additional tax on their wage increase, or on their bonus at work – so why is this happening?

Those that are earning under £125,140, are higher rate tax payers (not additional rate tax payers) so why are they being taxed at 60% on some of their earnings?

The additional rate of income tax band begins at £125,1240, but it’s the income band between £100,00 and £125,140 which is a crucial one to be aware of here.

Once your income enters this band, regardless of whether it is salary or bonus it begins to reduce your personal allowance. Personal allowance, is the starting band that everyone can earn before paying any income tax is £12,570.

When in this income band, you lose 60p from each pound. For every pound your income is over £100,000, you lose 50p of your tax-free allowance – this means that the tax rate on earnings between £100,000 and £125,140 is effectively 60%. Once you reach £125,140 or above, your entire personal allowance has been wiped out.

These allowances (affecting you over £100,000) haven’t changed since 2010/11 when there were not as many people being affected. A salary of £100,000 is still (as it was a decade ago) a high income but the Institute for Fiscal Studies estimates that by 2025/26 approximately 1.6 million people will have some of their personal allowance withdrawn as the long-term freeze of this threshold starts to bite.

As well as affecting your personal allowance and tax, when you earn over £100,000 you are no longer entitled to tax-free childcare. This means you would not only be paying more tax, but also losing the childcare entitlement and paying more for childcare.

So, how can you reduce your taxable income, while still having the benefit of it? Why not consider pension contributions? This money remains yours but is invested for your future and comes with additional tax relief benefits, as well as saving you tax.

Everyone under the age of 75 receives 20% tax relief on their pension contributions immediately from the Government. For every £1 you put in, an extra 20% (which is 25p) will be added to that contribution.

However, if you are in this band of earnings, every £1 that goes into your pension, will cost you just 40p. If you pay in 80p, this is topped up by the basic rate of tax relief, meaning that £1 goes into your pension. However, when you inform HMRC (HM Revenue and Customs) of the £1 gross contribution via your tax return, this reduces your taxable income when working out the personal allowance therefore saving 60p in total. Out of the 60p, you have received 20p basic tax relief already into your pension and you will get a tax rebate of the remaining 40p.

Remember that you do not have to contribute the full amount over £100,000 into your pension, as you will get tax relief on your personal contribution. For example someone earning £115,000 doesn’t need to put £15,000 in to take them back to the band limit.

The example below may help to make this clear:

How much you actually pay into your pension: £12,000
Amount of basic-rate tax relief added: £3,000
Amount of higher-rate tax relief you can claim back: £6,000
The total amount of tax relief you earn: £9,000
The total cost of your pension contribution: £6,000

If you are part of a net pay arrangement with your employer, if contributed via your wages you will immediately get the full 40% relief on your contribution. There is also an option of salary sacrifice which can be explored with employers which could be more attractive.

The additional tax relief you will only receive if you let HMRC know that you have made this contribution via a tax return.

The Financial Conduct Authority does not regulate taxation advice

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