May 16, 2008 6:37 pm

Tax relief on pensions boosted

Taxpayers who have suddenly found themselves in the 40 per cent income tax band as a result of the chancellor’s “mini-Budget” are being urged to take a look at their pension contributions.

The chancellor’s decision this week to reduce the higher-rate tax threshold from £41,435 to £40,835, as part of his £2.7bn cash handout to poorer households, has pushed 150,000 more people into the top rate of tax.

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Although the increase in personal allowances means these individuals will not pay any more tax on their income, accountants say a consequence of the changes is that they can now claim greater relief on contributions made to pensions.

“The benefits are quite marginal, but given the intention of the plan to help poor households rather than wealthy ones, they are still an oddity,” says John Whiting, tax partner at PwC. The new scheme has also come under criticism for failing to help 1.1m poorer households affected by the loss of the 10p tax band.

The chancellor announced that he was increasing the personal income tax allowance by £600 in order to mitigate the negative effects of the abolition of the 10 per cent starter tax rate two months ago.

As a result, 22m people on low and middle incomes will be £120 better off. The changes will not be seen on pay packets until September.

But to target the benefits at lower-income households, the chancellor reduced the 20 per cent tax band from £36,000 to £34,800, thus negating the gain of £600 for high earners.

Taking as an example an individual who earns £50,000, it is possible to break down the alterations to the tax bands to show how the effect on annual income tax for higher rate taxpayers will be neutral.

Before the increase in allowances, the first £5,435 of £50,000 would remain untaxed. The next £36,000 would be taxed at 20 per cent and the final £8,565 taxed at 40 per cent. The total tax bill would come to £10,626.

As a result of the chancellor’s changes, the first £6,035 will now be untaxed. The next £34,800 will be taxed at 20 per cent and the last £9,165 at 40 per cent. The total tax bill remains unchanged at £10,626.

The trade-off for any individual who moves into a higher tax band is that tax relief for any contributions they make to pensions or to charities via gift aid also increases.

For an individual with an income of £50,000, previous tax rates meant they could claim 40 per cent tax relief on £8,565 worth of savings made into a pension.

By moving the higher rate tax threshold, the government has enabled the same individual to claim higher rate relief on £9,165 of their income: a gain of £600.

This, say financial advisers, makes a compelling argument for those people who have now come into the higher rate tax band to ensure that their pension contributions are set up to take advantage of this.

Francesca Lagerberg, senior tax partner at Grant Thornton, calls the benefit “the law of unintended consequences”. “It’s a reflection of the complexity of our tax system,” she says. “If you make any kind of change there will be a knock-on effect.”

Some, such as pension savers, may benefit. Others, she says, such as non-domiciles who elect to be taxed on a remittance basis, face an increased tax burden as they miss a larger personal tax allowance.

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