August 19, 2011 7:04 pm

Can I reduce my tax by paying into a pension?

I am currently working full time but, since June, have begun to draw on two pensions. My estimated total income for the current tax year is now around £120,000, which means I have crossed the £115,000 earnings threshold and will lose my personal tax allowance of £7,475. This will cost me an extra £3,000 a year in tax. However, my current employer is about to implement an additional voluntary contribution (AVC) scheme for pension members. Can I regain my personal tax allowance if I pay £6,000 into the scheme before next April? And, if so, is this acceptable to HM Revenue & Customs (HMRC)?

Laith Khalaf, pension investment manager at Hargreaves Lansdown, says any personal contributions that you make into a pension will reduce your ‘adjusted net income’ for the purposes of determining your personal allowance. This is true of contributions that you make into your main workplace scheme, a workplace AVC, or indeed an individual pension arrangement of your choosing, and can result in an effective rate of tax relief of 60 per cent on those contributions. HMRC is happy with this arrangement. Indeed, its own guidelines set out how this works in practice.

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The standard personal allowance is £7,475 but it tapered down if you earn more than £100,000, reaching zero once you earn £114,950 or more.

So, to regain your entire personal allowance, you would need to bring your adjusted net income down to £100,000 or below. If you earn £120,000, you would therefore need to make pension contributions of £20,000 or more over the tax year to regain your personal allowance in full. It is, of course, possible to reclaim it in part by making a lesser contribution – but, in your case, you must contribute at least £5,050 before you start to regain it.

As well as regaining your personal allowance, you will also receive tax relief on your pension contributions. As a result, those earning between £100,000 and £114,950 effectively get 60 per cent tax relief on their pension contributions: higher-rate tax relief plus the reinstatement the personal allowance. By making a £20,000 contribution, you will benefit from this 60 per cent tax relief on £14,950 of your contribution, and the remaining £5,050 will receive 40 per cent tax relief.

In practical terms, to make a £20,000 individual pension contribution, you would only need to write a cheque for £16,000, because 20 per cent basic rate tax relief of £4,000 is added to your pension automatically. You are then entitled to reclaim a further £4,000 higher rate tax relief from the taxman. Finally, by regaining your personal allowance in full you save a further £7,475 of your income being exposed to 40 per cent tax, saving you a further £2,990.

So, all in all, you would save £10,990 in tax by making a £20,000 pension contribution. To put this another way, you would have made a pension contribution of £20,000 but, because of the tax savings, it would only cost you £9,010.

However, you must pay attention to the new annual contribution allowance of £50,000. You only get tax relief on contributions up to £50,000 each tax year, and this limit includes your employer’s contributions, too. But there is a generous ‘carry forward’ arrangement that allows you to carry forward any unused allowance from the last three years. As a result, you may be able to contribute more than £50,000 in practice.

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