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Reducing income tax and capital gains tax with the help of pension contributions

Publication date:

10 November 2016

Last updated:

18 December 2023

Author(s):

Technical Connection

Most taxpayers, especially higher rate/additional rate taxpayers, would be happy to hear about the possibility of saving income tax and/or capital gains tax whilst at the same time benefiting from tax relief.  The key to this is the payment of contributions to a registered pension plan linked to the personal tax situation of the individual taxpayer.

BACKGROUND

Contributions to registered pension plans are highly tax efficient.  Indeed, they are so tax efficient that the tax reliefs will inevitably remain under Government scrutiny and for this reason change cannot be ruled out in the future.

Within limits not only will pension contributions secure income tax relief on contributions (at the individual's top rate(s) of tax) but contributions are then invested in a fund that is free of tax on investment income and capital gains; and a part of the benefits can ultimately be drawn in the form of tax free cash.

However, the payment of pension contributions can confer other tax planning benefits for people in certain circumstances.  One of these is due to the way that higher rate tax relief is given on contributions to personal pension plans by certain people.  As is generally well known, basic rate tax relief is given at source so that 20% tax at source is deducted from any pension contribution paid to the provider.  Higher rate tax relief is given by increasing the individual's basic rate tax band.  This means more of the individual's income falls within basic rate tax rather than higher rate tax. 

What is not so readily appreciated is that because of the way the income tax relief is given, contributions to personal pension plans can indirectly provide other tax advantages - see later examples.

INCOME TAX

For example, the way that the income tax system works these days is that certain income tax allowances are cut back at key income thresholds.

Consider the following situations:

(a) People who are entitled to child benefit will find that if their adjusted net income exceeds £50,000, they will be subject to a high income child benefit tax charge which, in effect, gradually neutralises the entitlement to child benefit. At £60,000 all of the child benefit is effectively lost.

For people who have income in this £50,000-£60,000 band, a payment of a contribution to a personal pension plan can be very worthwhile.  As well as providing all the normal benefits given to pension plans, it can reduce adjusted net income and, in effect, restore some of the child benefit.

(b) Similarly, if a person has adjusted net income of more than £100,000, they will find that they start to lose a part of their personal allowance based on a £1 reduction for every £2 of adjusted net income over £100,000.  On 2016/17 rates, this means that when a person's adjusted net income reaches £122,000 all of their personal allowance is lost, ie £22,000 x 50% = £11,000.

It also means that any non-dividend income in this £22,000 range is effectively taxed at 60% - 40% as usual and an extra 20% in respect of the reduction of the personal allowance.

As pension contributions to a registered pension scheme can reduce adjusted net income, if there is scope to do so it makes sense for such people to make contributions - to in effect obtain tax relief at 60%.

Example - Will

Will's annual salary package in 2016/17 is £95,000.  He is delighted when he learns that his annual bonus for 2016/17 will be £15,000.  He is not so happy when he realises that £10,000 of this will effectively be taxed at 60% - because it will cause him to lose £5,000 of his personal allowance ie £10,000 /2 = £5,000.

By making an additional net contribution of £8,000 to his employer's group personal pension plan, he can reduce his adjusted net income (after addition of the bonus) to £100,000 meaning that he is now entitled to his full £11,000 personal allowance. In effect, his additional £10,000 gross pension contribution benefits from tax relief at 60%.

(c) People who are encashing single premium bonds will pay income tax on any chargeable event gains.  But if those bonds are UK bonds, the investor will only pay higher/additional rate tax. And in determining the amount of higher/additional rate tax payable, the individual can take account of top-slicing relief.  For such a person the payment of a contribution to a personal pension plan in the same tax year as the bond is encashed can lead to a reduction in the tax liability on the encashment of the bond.  Take Janice for example.

Example - Janice

Janice has earned income of £40,000 in 2016/17.  She is about to encash a UK single premium bond for £100,000.  She purchased the bond 5 years ago for £75,000 out of an inheritance from her aunt.

As the top-sliced gain of £5,000 will cause Janice's higher rate tax threshold (£43,000 in 2016/17) to be exceeded by £2,000 the tax computation on the chargeable event gain will be as follows:-

Chargeable event gain  

 

£25,000

Top-sliced gain

 

£ 5,000

Tax on gain

£3,000 - within basic

rate tax band              

£500 PSA @ 0% =

 

£        0

£        0

 

£1,500 @ 20% =

£    300

 

 

 

Tax on whole gain

 

£300 x 5

 

 

 

 

 

= £1,500

To reduce the impact of the tax on the chargeable event gain, Janice could pay a net contribution of £1,600 into a personal pension plan. Basic rate tax relief would be given at source. But in order to give higher rate tax relief her basic rate tax band will be increased by the grossed-up contribution of £2,000 to £34,000.  This means that the whole top-sliced chargeable event gain under the bond falls within the basic rate tax band. In turn this means that there will be no income tax on the chargeable event gain under the single premium bond.

CAPITAL GAINS TAX

Pension contributions can reduce tax on capital gains. Take Philip for example.

Example - Philip

Philip has earned income of £25,000 in tax year 2016/17.  The higher rate threshold for this tax year is £43,000 and the personal allowance is £11,000.

Philip has realised some shares in his employer company (that he acquired under an approved profit sharing scheme) for £63,100.  He plans to use the proceeds to help buy a caravan for £55,000 so has about £8,000 free for other use - including, of course, meeting any tax bill on the realisation.  He paid £30,000 for the shares so his taxable capital gain is therefore £33,100.  From this he can deduct his annual exemption of £11,100 leaving £22,000 taxable in 2016/17. As things stand his tax bill will therefore be:-

£18,000 in the basic rate tax band@ 10%

=

£1,800

£4,000 in the higher rate tax band @ 20%

=         

£   800

 

 

______

Total     

 

£2,600

 

 

 

This capital gains tax bill will be payable on 31 January 2018 and eat into the £8,000 in cash he has available after purchase of the caravan.

To reduce this tax bill Philip could consider making a net contribution of £3,200 to a personal pension plan.

For income tax purposes, this will increase his basic rate tax band from £32,000 to £36,000. This now means that all of the taxable capital gain is taxed at 10% within the basic rate tax band meaning he saves tax of £400.

So out of the £8,000 of cash after purchase of the caravan, Philip will use

  • £3,200 to make a contribution to a personal pension plan and
  • earmark £2,200 for payment of the reduced CGT bill on 31 January 2018

CONCLUSION

The above income tax strategies will be most relevant to higher/additional rate taxpayers.  The capital gains tax strategy can benefit basic rate taxpayers when the capital gain takes them into higher rate tax.  The prospect of an immediate income tax and/or capital gains tax saving, coupled with investment in a pension which, within limits, provides immediate tax relief and future gross roll up, is a potent combination which should appeal to most clients or at least give you a reason to call.

This document is believed to be accurate but is not intended as a basis of knowledge upon which advice can be given. Neither the author (personal or corporate), the CII group, local institute or Society, or any of the officers or employees of those organisations accept any responsibility for any loss occasioned to any person acting or refraining from action as a result of the data or opinions included in this material. Opinions expressed are those of the author or authors and not necessarily those of the CII group, local institutes, or Societies.