If an individual has been hit by the new higher tax rate introduced on the 6th April, John Lawson, head of pensions policy at Standard Life, shows how they can avoid it by paying a pension contribution.
This can effectively expand their basic rate tax band while allowing them to still benefit from the new higher personal allowance
If you would like to speak with John regarding this, or any other pensions related story, then please get in touch.
John said:
"According to accountancy firm, Grant Thornton, another 700,000 people would begin to pay higher rate tax from 6th April this year. This change will hit people not previously regarded as high earners including many nurses, junior doctors and police officers - particularly those who earn overtime or have local cost of living allowances.
The reason why more people are caught is due to a reduction in the income level at which higher rate tax starts. This stops higher rate taxpayers gaining from the £1,000 increase to the personal allowance. So, rather than start paying 40% tax when your income reaches £43,875, as happened in the 2010/11 tax year, higher rate tax starts at £42,475 this year.
Although the change is supposed to be income tax neutral, someone with income at or above £43,875 will pay £80 more income tax this tax year compared to 2010/11.
And it's not just income tax that's changing. The rate of national insurance for higher earners is rising from 1% to 2%. This rate starts when weekly earnings reach £817, which on an annual basis is £42,475 - the same as the income level at which higher rate income tax starts.
Thankfully, you can do something about it. By paying a pension contribution, you can effectively expand your basic rate tax band, avoid higher rate tax but still benefit from the new higher personal allowance. Here's an example:
Tom earns £45,000 a year. In 2010/11 he paid income tax of £7,930 and national insurance of £4,209. This left him with take-home pay of £32,861. If he earns the same amount this year then his tax bill will rise to £8,010 with £4,281 of national insurance on top, leaving him with £32,709.
By paying a gross pension contribution of £2,525, Tom will avoid higher rate tax and reduce his income tax bill by £1,010 to just £7,000.
If Tom is in an occupational pension scheme, he can pay this from his salary before tax is deducted and get the tax relief that way. Alternatively, if he saves in a personal pension, he will pay a contribution of £2,020 net of basic rate tax. This gives him immediate tax relief of £505 and he can claim the other £505 back at the end of the tax year. Either way, he will receive 40% tax relief on these personal contributions to his pension.
Even better, if Tom's employer offers salary sacrifice he can save on national insurance (NICs) payments too. Salary sacrifice means you give up part of your salary - in this case £2,525 - on the understanding that your employer will pay the amount sacrificed into a pension for you.
Reducing his pay in this way will save Tom another £51 in NICs, but his employer also saves £348 NICs. Many employers who offer salary sacrifice pay part or all of their NIC savings into the employee's pension. If Tom's employer paid the whole saving into his pension, Tom's total pension contribution would rise to £2873 at a net out of pocket cost to Tom of only £1,464.
This means that Tom receives tax relief at an effective rate of 49%, which makes such salary sacrifice deals extremely attractive."
Any reference to legislation and tax is based on Standard Life's understanding of United Kingdom law and HM Revenue & Customs practice at the date of production. These may be subject to change in the future. Tax rates and reliefs may be altered. No guarantees are given regarding the effectiveness of any arrangements entered into on the basis of these comments.
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