In this article we explain more on the process of making pension contributions and how you can maximise your tax saving opportunities.
Personal pensions can generally be accessed from between 55 and 57 years old depending on your date of birth and will be in addition to anything you receive from your state pension and potentially employment pensions.
Whilst the majority of people are eligible for a state pension, many would find it incredibly difficult to rely on this as their only income to fund their retirement. Hence it is highly advisable to start a personal pension to ensure you have sufficient funds to enjoy a comfortable retirement and in addition means you can benefit from a number of tax saving opportunities, which can include:
- Assuming you don’t exceed certain limits, a pension contribution will reduce your income for tax purposes thus saving tax at your highest rate
- If the contribution is made by your company, you will save corporation tax
- Whilst invested, your pension will not be subject to income tax or capital gains tax
- When you withdraw money from your pension, 25% of the funds will be tax free
- If you die before all the funds from your pension are spent, the remainder can generally be passed to your family without it incurring any inheritance tax, but this is dependent on circumstances.
Let’s start with the basics – how much tax will you save by making a pension contribution?
Self-employed pension contribution tax relief
For a self-employed individual, tax relief is generally obtained via what is known as a ‘relief at source’ scheme. This way, the personal pension scheme automatically claims relief from the government at the basic rate of tax. This ensures basic rate taxpayers receive tax relief. For higher rate taxpayers, additional relief is obtained by extending their basic rate tax bands when completing a self-assessment tax return.
If you are a basic rate taxpayer and want to save £1,000 into your personal pension plan, the effective cost to you is only £800. For a higher-rate taxpayer, to save £1,000 could effectively cost you as little as £600 (£590 in Scotland). The cost drops down further to only £550 (£540 in Scotland) for an additional rate taxpayer.
Sometimes, the tax saving is even higher (pension cost even lower) due to some quirks in the rules, which we explain further on.
Limited company director pension contribution tax relief
If you are a limited company director, there are a number of ways in which you can save tax, assuming your company makes a profit, and you use a typical dividend strategy for extracting money.
Normal practice is for the company to make the pension contribution for you as the director. As this is generally an allowable expense, your company profits are reduced and this saves the company corporation tax at 19%, 25% or even 26.5% depending on your profit level.
As profits are reduced, fewer dividends would be taken than would otherwise be needed to make a personal pension contribution. This saves the director personal tax, depending on the director’s total income and the tax bracket that falls within. The additional personal tax saving could be 8.75% (basic rate), 33.75% (higher rate) or 39.35% (additional rate).
Employees
For employees, the general practice is to deduct the pension contribution from the employee’s post tax salary and obtain relief at source, in a similar way to a self-employed individual. Alternatively, your employer may operate a net pay scheme where your pension contributions are made before you are taxed. You will usually therefore pay less tax because your tax will be calculated based on a lower amount of earnings. It is important to check what scheme your employer uses.
If however, your pension contribution is part of a salary sacrifice arrangement, this means that both the employee and employer potentially save national insurance on top of the income tax.
How much tax could you save?
| Based on a pension contribution of £10,000 – the below figures demonstrate how much the contribution would actually cost once tax relief’s are taken into account. | |||
|---|---|---|---|
| Income level | Self-employed | Employee | Director of Ltd (div strategy) |
| £30,000 | £8,000 | £8,000 | £7,391 |
| £70,000 | £6,000 | £6,000 | £4,869* |
| £110,000^ | £4,000 | £4,000 | £3,182* |
| £60,000^^ | £4,115 | £4,115 | £2,984* |
Tax Tips
* Assumes company profit between £50,000 and £250,000 paying corporation tax at 26.5%
^ Tax tip 1: If your income is over £100,000 then it’s possible to get very high rates of tax relief because a pension contribution can prevent the loss of your personal tax-free allowance which gets gradually removed as your income exceeds £100,000.
^^ Tax tip 2: The impact of child benefit and universal credit can make these tax reliefs even more extreme. The £60,000 example assumes two children and the person making the contribution is the only parent earning over £50,000. Normally child benefit would be lost as it is gradually removed as taxable income rises from £50,000 to £60,000. Reducing the income by £10,000 means the child benefit is no longer lost through additional tax charges and this saves £1,885 being £36.25 x 52 weeks for two children. This is in addition to the 40% income tax saving.
Making personal pension contributions is therefore a very efficient way of saving for retirement to avoid paying tax at high marginal rates. Equally, employer or company contributions save corporation tax and help avoid tax on dividends for those who take them as part of their profit extraction strategy. Of course, limits on pension relief do apply.
Are there limits on how much I can contribute into my pension?
A strategy for highly paid people for many years has been to make very large pension contributions to save tax. This led to the Government imposing restrictions on the amounts that can benefit from tax relief. Currently, the maximum that can be contributed per annum is £40,000 but this amount is reduced if your income exceeds £240,000.
In summary, the allowance of £40,000 reduces by £1 for every £2 of adjusted income above £240,000 however the allowance is always at least £4,000. For example, if income was £260,000 then that exceeds £240,000 by £20,000. Adjusted income is net income plus occupational pension contributions plus employer pension contributions. This means the allowance is cut by £1 for every £2 over the limit so is cut from £10,000 to £30,000. It’s important to note that employer contributions also count towards the allowance. If you contribute more than your allowance, this results in a tax bill.
Other restrictions apply to the amount that may be saved to a pension scheme and you should always seek advice if you are unsure how much you may contribute.
Unused pension allowance
If you have previously paid into a pension at any time, you may also be able to use unused pension allowances from the previous three years. If you haven’t made any contributions for a long-time, it may be possible to contribute as much as £160,000 in one-go which would be calculated from the previous three years allowance plus the current years allowance at £40,000.
Lifetime allowance
From 6th April 2023, you will be able to join and contribute to arrangements without facing a Lifetime Allowance tax charge.
It is important to be aware that there are a number of other rules which restrict the amount you may contribute to a pension, so you should fully review your position before taking action. Read our article on the changes to the Pension Lifetime Allowance, for more information.
How much do I need in my pension pot?
Everyone is different but assuming typical retirement age is between 60 to 65 years and average life expectancy is around 85 years, then most people will need to draw from their pension for around 25 years. Traditionally people bought an annuity with their pension pot enabling them to receive a guaranteed income for life.
However, although they have risen recently, annuity rates have been poor due to low-interest rates for the past decade. As a result, more and more people have decided to draw money from their pensions as they need it, keeping the money invested for the remainder of their lives.
If you decide not to buy an annuity then a sensible rule of thumb is to only withdraw 4-5% of your pension each year as this will substantially reduce the risk of running out. That means £20,000 to £25,000 could be withdrawn annually from a £500,000 pension pot.
A £500,000 pension pot may seem an ambitious target for many but depending on your lifestyle can provide a reasonably good income for your retirement if your mortgage is paid off and you are also in receipt of a state pension. You may also be in a situation where a partner has pension income to contribute towards your combined expenses and lifestyle.
On the assumption, however, that you decide not to buy an annuity, it’s important to know how your pension is invested and that you are not leaving anything to chance.
How we can help
Our Independent Financial Planners can conduct a full review of your pensions and investments to help you understand what you have in place already and what you need to do to secure the retirement lifestyle you desire. We can advise you on all aspects of your pension including:
- How big your pension pot needs to be to achieve the retirement income you require
- How much you may need to invest per annum to reach your pension pot target
- Whether your existing pension investments are performing well and whether they represent good value for money in terms of the charges you are incurring
- Whether your pension investments are taking too much or too little risk for your stage of life and your personal preferences
- If they are invested ethically, if this is an important consideration for you
- Pension consolidation and transfers - helping you bring all of your pension investments together, which can be useful to provide a clearer understanding and view of your overall savings
- How best to make new pension contributions to maximise the tax relief available to you and to avoid the pitfalls of over contributing
- What happens to your pensions when you die and how a spouse or family may benefit
- How to withdraw money from your pension during retirement and when you should access tax-free amounts
- Once you are a client, we can keep you up to date with your progression towards your retirement goals and help you make suitable adjustments to your investments, as a result of changes to your life or world events.
Find out more
Contact our team of expert and friendly Financial Planners to book a free initial consultation by calling 0330 441 2244, complete our enquiry form or email [email protected]