Reducing income tax through pension contributions

Last updated 24th January 2024

“Pension contributions are a great way to save money. In fact, they’re a fantastic investment.” Some things you don’t often hear in everyday conversation.

Strange, though, true.  And so few people know about it. A pension offers a highly tax-efficient way to invest your money and comes with flexibility around how you can access your capital when you retire. With a wide range of investment options, pensions can also be an excellent way to reduce your tax liability through tax relief.

Why is this such an overlooked area? Perhaps because it’s seen as complex, or “not for me”. See too one of our other articles explaining how personal pension contributions work.

At Henderson Loggie Financial Planning, we’ve been helping our clients maximise their financial potential for over 20 years. We love our subject, and we love to grow our knowledge and understanding of the financial systems. Therefore changes to legislation are embraced.

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How do I make pensions work for me?

If you are a higher rate or additional rate taxpayer

Generally, when you pay contributions to your pensions, you will receive basic rate tax relief.

If you pay £1,000 into your personal pension, for example, basic rate tax relief at 20% is added to your contribution, increasing its value, resulting in £1,250 being invested in your fund. However, in order to receive higher rate tax relief this must be reclaimed via HMRC. By reclaiming the higher rate tax relief you will reduce your income tax bill for the year.

If you’re an employee paying to your workplace pension, tax relief works the same way to the example above. However, you might be part of a Salary Exchange scheme (also known as salary sacrifice). This is where your employer pays all your pension contributions by you exchanging part of your salary for a pension contribution. If you benefit from this contribution method you will receive tax relief at your highest rate payable immediately, and benefit from a reduction in your National Insurance contributions. This method of contribution negates the need to reclaim your higher rate tax relief.

To bring an example of paying personal pension contributions to life, let’s focus on some scenarios of why considering the use of pension contributions to reduce your income tax bill is worth it.

If you earn over £100,000

Let’s say Amanda earns a good salary of £115,000 and contributes £4,000 net to her personal pension.

Amanda’s current position:

• After basic rate tax relief is added to her £4,000, a total pension contribution of £5,000
• A total income tax bill for the year of £37,338
• Higher rate tax liability is £29,962
• Earning over £100,000 reduces her personal allowance from £12,570 to £7,570, therefore increasing the overall income tax Amanda pays.
  • Personal allowance reduces £1 for every £2 earned over £100,000. Earnings over £125,140 reduces a personal allowance to zero.

Note: All calculations are based on Amanda being a Scottish taxpayer.

Let’s look at how an additional £8,000 (net) pension contribution can improve Amanda’s financial situation:

• After basic rate tax relief is added, an additional £10,000 is paid to her pension plan
• Amanda’s total income tax for the year reduces to £31,938, saving her £5,400
• Higher rate tax liability reduces to £21,562, a reduction of £8,400
• Making an additional pension payment had the effect of reducing her income to £100,000 resulting in the full personal allowance of £12,570 being available again

When considering pension tax relief, the return of the full personal allowance and the income tax savings from the additional pension payment, Amanda benefits from an effective rate of tax relief of 56%.

If you earn over £50,000 and receive Child Benefit

Stuart earns £60,000 and contributes £3,000 (net) to his pension plan. Stuart has 2 children under the age of 18 and receives child benefit payments.

Stuarts current position:

• A total pension contribution of £3,750
• Total income tax payable £13,699
• Of this tax, £1,286 is a Child Benefit tax charge.

If you earn between £50,000 and £60,000 the entitlement to the child benefit payment you receive over the tax year reduces. The reduction is 1% per £100 earned over £50,000. So for example, if someone earns £51,000 the entitlement to Child Benefit reduces by 10%. However, even though earnings exceed £50,000 Child Benefit payments continue being paid at the full entitlement level, hence why there is an annual tax charge.

This is where pension contributions can be useful. Whether it’s an occupational pension scheme or a personal pension you’re contributing to, your contribution total will reduce the final amount of “adjusted net income” as it’s known. If the adjusted figure is below £50,000, the charge is avoided completely if it lies somewhere between £50,000 and £60,000, it’s reduced.

In Stuart’s example, if he contributes another £5,000 (net), his financial position improves:

• With the addition of tax relief, another £6,000 is paid to his pension
• The total tax payable is £10,213, a reduction of £3,486
• There is no Child Benefit tax charge

All the information you need is here at gov.uk Child Benefit Tax Charge; alternatively, have a word with one of our experts to see how this might help you.

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Let’s wrap up

If you’re a higher rate or additional rate taxpayer, the extra tax relief that’s applied means that saving via a personal or workplace pension is doubly worthwhile and can boost your funds for retirement. Henderson Loggie Financial Planning’s friendly, knowledgeable team has all the resources you need to ensure that you’re not giving away valuable, hard-earned funds in unnecessary tax when you don’t need to.