Miss A, Vet Surgeon earning £125,000pa came to see us for a holistic financial planning service. She was concerned about protecting her income in the event of long term absence of work during illness or disability and dying intestate as she was living with her partner. She was a member of her company pension scheme.
We identified that she was losing all of her personal allowance for income tax of £12,500 (2020/21) because she was earning more than £100,000pa. One of our recommendations was to invest in her pension the amount needed to bring her 'adjusted net income' to below £100,000pa.
The following notes explain how high earners can obtain substantial tax savings through pension planning:
Higher Income Earners Income between £100,000 and £125,000
Once your income exceeds £100,000 your income tax personal allowance is gradually taken away. It is reduced by £1 for every £2 you earn above £100,000. For example, since Miss A's income was £125,000 her personal allowance was reduced by £12,500. The income tax personal allowance for the 2020/21 tax year is £12,500. So she had no personal allowance at all. This is a real tax sting for those earning over £100,000.
The personal allowance currently saves you £5,000 in tax if you are a higher-rate taxpayer.
Paying Tax at 60%
The effect of having the personal allowance taken away is that anyone earning between £100,000 and £125,000 faces a hefty marginal income tax rate of 60%. For example, Miss A who earns £125,000 will pay 40% tax on the extra income above £100,000 (tax due £25,000 x 40% = £10,000). She’ll also have her personal allowance taken away, which means she’ll have to pay an extra £5,000 in tax (£12,500 x 40%). Total tax on extra income: £15,000, which is 60% of the extra £25,000 above £100,000 income.
Saving Tax at 60%
The flipside of this is that anyone in this income bracket who makes pension contributions can currently enjoy 60% tax relief. Your personal allowance is reduced if your ‘adjusted net income’ is more than £100,000. When calculating your 'adjusted net income' you usually deduct any pension contributions you have made. For example, Miss A had taxable income of £125,000 and advised to invest £20,000 in her pension. She will receive a £5,000 top up from the taxman ( basic-rate tax relief), resulting in a gross pension contribution of £25,000. She will also receive higher rate tax relief of £5,000 (£25,000 x 20%). In addition, by making a gross pension of £25,000 her ‘adjusted net income’ will be reduced from £125,000 to £100,000, so none of her personal allowance will be taken away. Additional tax saving: £5,000 (£12,500 x 40%). In summary, her £25,000 pension contribution produces £15,000 of tax savings – a total of 60% tax relief!
Income over £125,000
Once your income rises above £125,000 your marginal income tax rate falls back to 40%. However, making quite big pension contributions can still be attractive because you may still get 60% tax relief on some of the money you put away. For example, let’s say you have taxable income of £135,000 and put £28,000 into a pension. Like anyone else you will receive £7,000 basic-rate tax relief, resulting in a gross pension contribution of £35,000. And like any other higher-rate taxpayer you will receive an additional £7,000 of higher-rate relief (£35,000 x 20%). In addition, your £35,000 gross pension contribution will reduce your 'adjusted net income' from £135,000 to £100,000, so none of your personal allowance will be taken away. Additional tax saving: £5,000 (£12,500 x 40%). In summary, your £35,000 gross pension contribution produces £19,000 of tax savings – a total of 54% tax relief.
In fact, anyone with taxable income up to £150,000 will enjoy at least 50% tax relief by making a gross pension contribution that’s big enough to take their 'adjusted net income' back down to £100,000. For example, someone with taxable income of £150,000 would need to make a gross pension contribution of £50,000 to take their 'adjusted net income' back down to £100,000 and enjoy exactly 50% tax relief.
Although the tax relief is attractive, that’s a big pension contribution, so in practice this strategy may appeal most to those whose income is only slightly higher than the £125,000 threshold. Furthermore, pension contributions in excess of £40,000 will exceed the annual allowance and are only possible if you have unused annual allowance from the three previous tax years.
When your income rises above £150,000 you become an additional-rate taxpayer and start paying tax at 45% on most types of income. The flipside is you can enjoy 45% tax relief on your pension contributions. However, some additional-rate taxpayers face greater restrictions to their pension contributions than other taxpayers. The annual allowance – the maximum amount that can be invested in a pension each year – can be reduced from £40,000 to just £4,000.
Fortunately, following an announcement in the March 2020 Budget, this pension taper now only kicks in at much higher income levels than previously. As a result, many high earners can benefit from much higher pension contributions than before.