The top rate of tax falls from 50% to 45% in the 2013/14 tax year, which also means a reduction in pension tax relief for those affected. By making additional pension contributions before April 5th, 50% taxpayers could save thousands of pounds.
Billy Mackay, Marketing Director for investment platform provider A J Bell, says there are a number of practical steps that people can take to maximise available tax reliefs and reduce potential liabilities in the run up to the new tax year.
For higher earners, it makes sense to make the most of the three-year carry-forward rule. This allows individuals who have used up all of their current tax year’s allowance to use any unused pension allowance from 2009/10, 2010/11 or 2011/12.
Says Billy Mackay, Marketing Director of investment platform provider A J Bell: "If a person has used all their £50,000 annual allowance in the 2012/13 tax year, carry-forward may be a useful tax-planning tool that will allow them to make a large pension contribution without being penalised for breaching the £50,000 annual pension allowance."
"If no pension contributions had been made in any of the three preceding tax years, an individual may be able to contribute an extra £150,000 in the current tax year. If they are a top rate taxpayer, they would also benefit from the current 50% income tax relief available to them on pension contributions, which will fall to 45% from April this year."
The personal allowance is the initial portion of income which most people receive that is free of any tax. At the moment this amounts to £8,105.
Since 2010/11 any individual earning more than £100,000 will have seen their personal allowance reduced, potentially to nothing, because for every £2 earned over £100,000 the personal allowance is reduced by £1. Anyone earning more than £116,210 in the 2012/13 tax year will not benefit from any personal allowance at all. So as well as paying 40% tax on the earnings from £100,000 to £116,210, they are losing their band of earnings which is free of tax at a 20% rate. They are effectively paying up to 60% tax on this portion of their earnings.
Says Mackay: “Pension contributions are deducted from an individual’s income before the personal allowanceis calculated. This means clients with an income above £100,000 may wish to consider the payment of pension contributions in order to bring their income down to a level where they will not face a reduction in their personal allowance– or to put it another way, they could effectively receive 60% tax relief by making these contributions.”
Says Mackay: “The main benefit of contributions for higher or additional rate taxpayers is that the tax relief reduces the amount of income which is subject to tax at either 40% or 50%. So, for example, someone with £10,000 of their income subject to tax at 40% can make an equivalent contribution to their pension to completely remove any liability to tax at
40%
“A person earning £60,000 pays tax at 20% on £34,370 (£6,874 tax) and at 40% on £17,525 (£7,010 tax). The total income tax liability here is £13,884. If this individual makes a pension contribution of £17,525, their total income tax would be reduced by £7,010, or 40% of their contribution, to £6,874.”
Tax relief on pension contributions is given at the marginal rate of tax paid by the individual paying the contribution.
This means that someone earning £25,000 will receive 20% tax relief on a contribution of £2,500; someone earning £50,000 will receive 40% tax relief on a contribution of £5,000. Someone earning £200,000 will receive 50% tax relief on a contribution of £40,000. In practise this means the £40,000 pension contribution has only cost them £20,000, with basic rate tax relief recovered immediately at 20% and a further 30%, or £12,000, reclaimed via self-assessment.
Says Mackay: “From 6 April 2013 the 50% additional rate of tax falls to 45%. This will reduce the extra tax relief available to people earning £150,000 or more.
“This means that a 45% taxpayer will receive up to £2,500 less in tax relief on a £50,000 pension contribution than they would when they were a 50% taxpayer. It therefore makes sense to maximise pension contributions before the tax year end to benefit from the more generous level of tax relief and thereby also reduce total income tax liability.”
Flexible drawdown allows a person to take unlimited amounts out of their pension scheme. In order to be eligible for flexible drawdown you must satisfy a secure Minimum Income Requirement (MIR) of £20,000 a year. All flexible drawdown payments are taxed as income in the same way as other pension payments and withdrawn money could also be liable to other taxes.
Says Mackay: “Moving large sums out of the tax-relieved environment of a pension – in which not only are contributions tax-free, but there is no CGT or IHT on death benefit lump sums – opens up the possibility incurring all sorts of unanticipated tax liabilities.
“To minimise these potential liabilities individuals might want to keep flexible drawdown withdrawals within the basic rate income tax threshold of 20%, rather than risk paying up to 50% on larger amounts.
“People should also remember that any money moved into drawdown immediately becomes liable to tax at 55% on the death of the individual. Withdrawing money in annual tranches, rather than in one go, will minimise the amount exposed to this charge.”