Where are the tax planning opportunities in pensions?
Now that the dust has settled over the storm in this year’s budget on the aborted introduction of the ‘pasty tax’, perhaps it is a good time to focus on some of the actual opportunities that have arisen in relation to pensions. Prior to the budget, there were many scaremongers speculating on the demise of higher rate tax relief for individual pension contributions.
I did not share this view personally, for two reasons. The first was that there had been substantial reductions in the previous year in both the annual and lifetime allowances and secondly, and probably more importantly, individuals had to be incentivised to save for retirement.
For higher rate taxpayers, who are more likely to be able to afford to save for retirement, full tax relief on contributions is a prime motivator. Removal of such incentives would only add to the burgeoning proportion of the population making insufficient financial provision for retirement while adding to the future unaffordable financial strain placed on the state.
That said, nobody knows what may happen in the longer term, and therefore it makes good sense to maximise the tax advantages that are currently available.
With the Government striving for the provision of a higher personal allowance of £10,000 pa, it has to balance this lost revenue by a corresponding reduction in the threshold that an individual needs to earn before becoming a higher rate taxpayer.
The higher rate tax threshold has reduced from £37,400 in 2010/11 to £34,370 for 2012/13 and will further reduce to £32,245 in 2013/14. That is a £5,155 reduction and takes the higher rate tax threshold back to around the level that it was at in 2005/06. As a result, it is estimated that in the next two years, the number of higher rate taxpayers will increase from four to five million.
One unintended outcome of this, given the Government’s need to increase the tax-take, is that more people will qualify for higher rate tax relief on their pension contributions.
That said, many individuals might be oblivious to this, particularly those who have had little or no increase in actual income over the last few years. It is therefore important for advisers to make those clients affected by this aware of the position, and also the benefits of tax relief on their personal pension contributions.
Another consequence of the increase in the personal allowance is that, for those in the fortunate position of having ‘adjusted net income’ in excess of £100,000, they will now have to pay a marginal rate of tax of 60% on a greater proportion of their income.
The reason for this is that for every £2 of income above £100,000 that the individual receives, they lose £1 of their personal allowance. Currently those earning between £100,000 and £116,120 will effectively pay tax at a rate of 60% on this band of income.
When the personalallowance rises to the proposed £10,000 pa, the 60% band will expand to cover income in excess of £100,000 up to £120,000. The good news for those who find themselves in this position is that individual pension contributions reduce ‘adjusted net income’ and so, in effect, they can receive 60% tax relief.
‘Adjusted net income’ is basically total income subject to tax, less trading losses, gross gift aid donations and all grossed up individual pension contributions.
The significance of ‘adjusted net income’ may also become relevant for those who currently receive child benefit. From 7 January 2013, if a family receives child benefit and a parent has ‘adjusted net income’ in excess of £50,000, they will be subject to the new child benefit income tax charge (CBITC).
For every £100 earned above £50,000 the CBITC will equate to 1% of the child benefit received. Thus, for anyone with ‘adjusted net income’ in excess of £60,000, the CBITC will, in effect, cancel out any child benefit received.
HMRC estimates that 1.2 million families will be affected by the CBITC. As stated previously, individual contributions reduce ‘adjusted net income’ and so they could provide an extremely beneficial outcome. For example, an individual with two children and income of £60,000 would be entitled to child benefit of £1,752 in 2013/14, effectively receiving tax relief of 57.52% on any gross pension contribution up to £10,000. Many individuals who are caught by the CBITC will not be aware of this opportunity and instead may decide to elect to not receive any child benefit.
Elaborating further on the Government’s current policy of announcing tax rate changes well in advance of their actual introduction; this provides advisers with a window of opportunity to give clients tax saving advice that has a specific ‘sell-by’ date, that may be a motivator in getting clients to act on the advice given.
For example, the additional rate of income tax is to be reduced from 50% to 45% from 6 April 2013, so for clients now paying 50% tax, they will loose out on the maximum tax relief available if they delay making personal pension contributions until the next tax year.
Also, the ability to carry forward any unused annual allowance from previous years would be better used when tax relief can be obtained at 50% rather than the reduced rate of 45% that is to be introduced next year.
An individual who is an additional rate taxpayer and is in a position to make a gross personal contribution of £100,000 this tax year, has effectively a net contribution £61,538, whereas if they defer making the contribution until the next tax year, their net contribution rises to £64,000.
In other words, where clients have high earnings this year and unused annual allowances from the previous three years, now is the time to act. Developing this idea further; take an individual who is planning to retire soon and is in a position to make a gross contribution of £100,000 to a SIPP that offers flexible drawdown.
Assuming that they get marginal rate tax relief at 50% and there is no annual allowance charge, as carry forward is available, and presuming they can meet the minimum income requirements from other pension income sources, the position in the new tax year will be as follows;
In addition to taking their pension commencement lump sum (PCLS) of £25,000, they can ‘strip’ the remaining pension fund. Depending on whether they were a 40% or 45% taxpayer in the new tax year, they have turned a £50,000 net contribution into either £70,000 net, or £66,250 net. The contribution of course must not be caught by the recycling legislation.
The ongoing plan to reduce the main rate of corporation tax was also confirmed; the rate reduced from 26% to 24% with further reductions of 1% over the next two years, by of which time it will have reduced to 22%. The Chancellor also stated he would like to see the main rate brought down to 20% in due course.
Forewarned by this, it makes sense for companies to incur allowable deductible expenditure now, offsetting the expenditure against the higher rate of corporation tax.
This of course includes making pension contributions, providing they meet the ‘wholly and exclusively’ test.
Companies with profits between £300,000 and £1.5m this year pay a higher marginal rate, albeit this reduced from 27.5% to 25% and will fall further to 22.5% in 2014/2015, and likewise for them it makes sense to offset expenditure now.
Finally, with business owners looking to reduce costs and simultaneously employees grappling with high inflation and low, or non-existent, pay increases, there has never been a better time for advisers to revisit the benefits of salary sacrifice.
There are few arrangements available that benefit both employer and employee at no additional cost, and more importantly are not contentious with HMRC.
The principle behind salary sacrifice is quite simple; an individual gives up the right to part of their salary in return for the employer agreeing to provide a non cash benefit.
It is most commonly used where the employer makes a pension contribution in lieu of part of the employee’s salary. The national insurance (NI) saved by the employee is used to boost the amount paid to their pension, as could all or part of the NI saved by the employer.
For example, an employee currently earning £49,000 pa and who makes a personal pension contribution of £2,400 net (£3,000 gross) agrees to sacrifice £3,103.
If the employer uses the salary sacrificed to make an employer pension contribution, an additional £103 has been paid to the pension even though the employee’s disposable income remains unchanged.
While the sum involved may not seem that great an incentive, the employer has also saved £428 (£3,103 x 13.8%) in employer NI contributions, and if they were prepared to contribute this saving to the employee’s pension, the gross contribution would now be £3,531, a 17.7% increase.
If that appears impressive, then consider a second example where the employee earns a salary of £40,000 and also contributes £2,400 net to their pension. Any salary sacrificed would save NI at the rate of 12%, and if they sacrificed £3,529 of their salary, their net disposable income would remain the same. Again if the employer contributed the £487 saved in employer NI, the gross pension contribution would be £4,016, a not insignificant 34% increase.
Pensions have come in for a bit of a rough ride over the last few years but they still provide the most tax effective way to save for retirement.
Making clients aware of the actual tax rates they pay and how pension contributions can reduce these is a key message.
Hopefully maximising the tax savings now will ensure your clients have a financially secure retirement that enables them to afford the little luxuries in life such as a warm pasty.
Neil MacGillivray is head of technical support at James Hay Partnership