February 4, 2011 6:33 pm

How to avoid 40% tax and boost your pension

Almost 4m people face paying higher-rate tax from April, but some higher earners can avoid the 40 per cent rate altogether by boosting their pension contributions.

The Institute of Fiscal Studies said this week that about 750,000 basic-rate taxpayers are set to pay 40 per cent tax for the first time in 2011/12 as a result of the reduction in the higher-rate threshold from £43,875 to £42,475 that was announced in last summer’s Budget.

This will take the total number of higher-rate taxpayers close to the peak levels of just before the recession, according to Grant Thornton, the accountants. It also means that existing higher-rate taxpayers will pay 40 per cent on more of their earnings.

However, taxpayers who contribute more to their pensions can reduce these bills and even avoid paying any tax at the 40 per cent rate.

“Higher-rate relief is a very attractive upfront tax break for wealthier pension savers – especially as they may pay only up to 20 per cent on their pension in retirement,” says Laith Khalaf, pensions analyst at Hargreaves Lansdown, the financial adviser.

For a higher-rate taxpayer, each £1,000 contributed to a personal pension offers a £250 reduction in their tax bill on top of the same amount of basic-rate relief.

The additional higher-rate relief generally needs to be reclaimed through a tax return, while the basic-rate relief is added automatically to the plan value – boosting a £1,000 contribution to £1,250.

CandidMoney.com, an advisory website, gives the example of a higher-rate taxpayer earning £65,000 with £1,000 of taxable savings interest – whose total income tax liability could be as much as £16,330 this year.

However, by paying £14,800 into a personal pension, as well as contributing to an occupational pension and donating tax-efficiently to charity, the person could reduce the higher-rate tax by £4,500 and boost his or her pension fund by a total of £28,250, including £4,350 of basic-rate relief. The tax savings and relief would total £8,850, the amount of tax otherwise payable at 40 per cent.

Justin Modray of CandidMoney.com says: “This is the nirvana situation, but even getting some way there can yield sizeable benefits.”

Many investors may not have the spare cash to top up their pensions. But if they have non-pension investments they could get the tax relief by switching these into a self-invested personal pension (Sipp).

To reduce tax bills for the current year, contributions must be made by April 5, although cash need not be invested until a later date.

For those earning just over £100,000, paying into a pension can also allow personal allowances to be reclaimed – effectively giving them up to 60 per cent tax relief on contributions.

Although there are tax relief restrictions for some high earners, this affects only those with incomes of more than £130,000 in the current tax year, while from April the contribution allowance for all pension savers is capped at £50,000.

People wanting to calculate how much to contribute to a personal pension to wipe out a higher-rate tax liability need to work out how much income they have above the 40 per cent threshold, then multiply this figure by 0.8. They also need to reduce their higher-rate earnings figure to take account of sums already getting tax relief – contributions to occupational pensions, for example.

In simple terms, investors on an income of £53,875 – £10,000 more than the current £43,875 threshold – could get 40 per cent tax relief on up to £8,000 of contributions, depending on the other reliefs they qualify for. If they contribute more, they simply receive basic-rate relief on the excess.

Making donations under Gift Aid yields the same additional relief as a pension to a 40 per cent taxpayer, while the basic-rate relief goes to the charity.

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