Reducing tax bills is a top priority for many people planning their finances. A great way to reduce tax bills while building up your retirement savings is by making pension contributions. Pensions are tax-efficient investment vehicles that offer significant benefits, including tax relief on contributions, tax-free growth within the fund, and flexible options for accessing your savings. In this blog post, we will explore how to reduce your tax bill through pension contributions to make the best of your income.
A pension contribution is a payment made to a pension scheme, which is used to build up your retirement savings. You can contribute to a pension scheme personally, through your employer, or through a combination of both. The amount you can contribute to your pension depends on your age, earnings, and the type of pension scheme you have.
One of the significant advantages of pension contributions is tax relief. Tax relief is a way for the UK government to incentivise people to save for retirement. The government adds tax relief to your pension contributions, which reduces the amount of tax you pay.
How Does Tax Relief on Pension Contributions Work?
Tax relief on pension contributions works by adding basic rate tax relief to your pension contributions automatically. This means that for every £100 you contribute to your pension, the government adds £25, making your total contribution £125.
If you are a higher-rate taxpayer, you can claim an additional 20% tax relief on your pension contributions through your individual tas return, meaning that you will receive a total of 40% tax relief. If you are an additional-rate taxpayer, you can claim an additional 25% tax relief, meaning that you will receive a total of 45% tax relief.
The amount of tax relief you receive is limited to your annual allowance. Your annual allowance is the maximum amount you can contribute to your pension each year without incurring a tax charge. The current annual allowance is £60,000 or 100% of your earnings, whichever is lower. However, this amount can be reduced if you have a high income or have started taking money from your pension.
If you are employed, you may be eligible for employer contributions to your pension. Employer contributions are payments made by your employer to your pension scheme on your behalf. These contributions are separate from your salary and do not count towards your annual allowance.
Employer contributions are a valuable benefit, as they can significantly increase the amount of money you have in your pension. Some employers offer matching contributions, where they match your contributions up to a certain amount. This can be a great way to boost your pension savings and reduce your tax bill.
Workplace Pension Schemes
Workplace pension schemes are pension schemes offered by employers to their employees. All employers in the UK are required to offer a workplace pension scheme under the auto-enrolment rules. Under these rules, employers must automatically enroll their employees in a workplace pension scheme and make minimum contributions to their pension.
Workplace pension schemes are a great way to save for retirement, as they offer tax relief on contributions and the potential for employer contributions. If your employer offers a workplace pension scheme, you should consider joining it and making the most of the tax benefits available.
1. Maximise Your Pension Contributions
The more you contribute to your pension, the more tax relief you will receive. If you have unused annual allowance from previous years, you can carry it forward and use it to make larger contributions. This can be particularly beneficial if you are approaching retirement and want to boost your pension savings.
2. Consider Salary Sacrifice
Salary sacrifice is when you agree to give up part of your salary in exchange for an employer pension contribution. This can be a tax-efficient way of saving for retirement, as you will receive both employer and government contributions on the sacrificed amount. It can also reduce your taxable income, which can lower your tax bill.
Suppose you earn £150,000 a year and decide to sacrifice £10,000 of your salary into your pension scheme. In that case, your taxable income will be reduced to £140,000, potentially moving you into a lower tax bracket.
3. Use Pension Freedoms
Pension freedoms, introduced in 2015, allow you to access your pension savings flexibly from the age of 55. You can take up to 25% of your pension as a tax-free lump sum, and the remainder can be taken as taxable income. By managing your withdrawals carefully, you can minimise the amount of tax you pay on your pension income.
For example, suppose you take your entire pension pot in one go. In that case, you will have to pay income tax on the whole amount, which could result in a significant tax bill. However, if you take smaller withdrawals over a more extended period, you could reduce your taxable income and pay less in tax.
4. Use Your Pension to Pay off Debt
If you have debts, such as a mortgage or credit card balances, you can use your pension to pay them off. This can be a tax-efficient way of reducing your debt, as you will not have to pay tax on the amount you withdraw from your pension. However, you should be aware that taking money from your pension will reduce your retirement income, so you should consider this carefully before making any decisions.
5. Make the Most of Carry Forward Rules
Carry forward rules allow you to use any unused annual allowance from the past three years to make pension contributions. This means that if you have not used your full allowance in previous years, you can carry it forward and make larger contributions. This can be particularly useful if you have a high income in a particular year and want to reduce your tax bill.
6. Lifetime Allowance was abolished
The lifetime allowance was the maximum amount you can save in your pension over your lifetime before incurring a tax charge. On the Spring Budget, the government announced the removal of the Lifetime Allowance charge from 5 April 2023 with its complete abolition from April 2024.
The removal of a limit for Lifetime Allowance means that pensions can increasingly be used as an estate planning tool since inheritance tax is not charged on pensions.
7. Use Pension Contributions to Pass on Wealth
One of the lesser-known benefits of pension contributions is that they can be used to pass on wealth to future generations tax-efficiently. If you die before the age of 75, your pension can be passed on to your beneficiaries tax-free. If you die after the age of 75, your beneficiaries will pay income tax on the pension at their marginal rate.
However, by setting up a pension trust, you can pass on your pension to your beneficiaries tax-efficiently. This can be particularly beneficial if you have a substantial pension pot and want to pass it on to your children or grandchildren.
8. Use a Self-Invested Personal Pension (SIPP)
A Self-Invested Personal Pension (SIPP) is a type of pension that allows you to choose how your money is invested. This can be beneficial for high-earning individuals who want more control over their investments. SIPPs offer a wide range of investment options, including stocks and shares, commercial property, and alternative investments.
SIPPs will not be suitable for everybody and generally only those who are fairly experienced at actively managing their investment should consider this type of investment. The levels and bases of taxation and reliefs from taxation can change at any time and are dependent on individual circumstances. The value of a SIPP can fall as well as rise. You may get back less than the amount invested.
9. Consider Pension Contributions for Your Spouse or Partner
If your spouse or partner is not earning, you can still make pension contributions on their behalf and receive tax relief. This can be a tax-efficient way of building up retirement savings for both of you, particularly if you have used up your annual allowance.
10. Maximise Employer Contributions
If your employer offers a workplace pension scheme, you should take advantage of any employer contributions on offer. Employer contributions are a valuable benefit, as they can significantly increase the amount of money you have in your pension. Some employers offer matching contributions, where they match your contributions up to a certain amount. This can be a great way to boost your pension savings and reduce your tax bill.
In conclusion, making pension contributions can be a tax-efficient way of reducing your tax bill and building up your retirement savings. By maximising your contributions, using salary sacrifice, taking advantage of pension freedoms, using your pension to pay off debt, making the most of carry forward rules, using pension contributions to pass on wealth, using a SIPP, and considering pension contributions for your spouse or partner, you can reduce your tax bill and achieve your retirement goals. It's essential to understand the UK tax rules and regulations related to pensions and seek professional financial advice before making any significant financial decisions.
The value of an investment with St. James’s Place will be directly linked to the performance of the funds you select, and the value can therefore go down as well as up. You may get back less than you invested.
The levels and bases of taxation, and reliefs from taxation, can change at any time and are generally dependent on individual circumstances.