As a senior employee of a large multinational company, Lewis is well remunerated. He earns £100,000 per annum and his company pays a very generous 20 per cent of his salary into the group personal pension on his behalf. As well as this, he makes a personal pension contribution of 12 per cent of his salary.
Lewis has been fortunate enough to make full use of his annual allowance for the last four years.
Exactly midway through the tax year, Lewis is awarded a promotion and receives a 50 per cent pay rise. He wants to meet his adviser to find out what his pay rise will mean for his tax position.
The current position
Looking at the overall position for the tax year, Lewis has an income of £125,000 (£100,000/2 + £150,000/2). Using the same methodology, his gross personal pension contribution is £15,000 and his employer contribution is £25,000. In short, he has used up this year’s annual allowance.
However, while Lewis is expecting his extra salary to be taxed at 40 per cent, the pay rise will affect his personal allowance. Prior to the pay rise, his adjusted net income – in this case salary less gross personal pension contributions – would have been £88,000. Post the pay rise his adjusted net income for the tax year is £110,000. You lose £1 of your personal allowance for each £2 of adjusted net income above £100,000, with the personal allowance being fully lost at £123,000 of adjusted net income.
This personal allowance trap is effectively a 60 per cent rate of taxation for every £2 (40 per cent tax on the £2 plus 40 per cent tax on the lost £1 = £1.20/£2). So, while Lewis expected his tax bill for the £10,000 above the £100,000 to be £4,000, it is actually £6,000. It is worth noting that, in this example, Lewis’s adjusted net income is also the same as the threshold income for the tapered annual allowance. As this is not above £110,000, the taper is not an issue here.
Lewis’s adviser suggests one option to reduce his tax bill is to make a gift aid contribution. A £6,000 contribution would net a charity (or charities) £8,000 after gift aid. An extra £2,000 can be reclaimed via self-assessment to reduce adjusted net income. However, Lewis does not have strong enough leanings towards any particular charity for him to want to make such a large contribution.
The second option the adviser suggests is to make an £8,000 net contribution to his GPP. Lewis is confused by this proposal as he is aware he has used up his entire annual allowance for this year and he has no carry forward available.
His adviser explains the benefits of taking this course of action. The annual allowance tax charge is added to your adjusted net income as if it were taxable income and taxed at the applicable marginal rate. It does not actually affect Lewis’s tax relief and he has sufficient relevant earnings to justify this. But the pension contribution will reduce his adjusted net income to £100,000 (as the contribution is £10,000 gross). Therefore, there will be a £4,000 annual allowance charge to pay.
So, for an initial outlay of £8,000, Lewis will regain his personal allowance. He will get £2,000 relief at source added to his pension and can reclaim a further £2,000 in his tax return. He also saves £2,000 in tax by not being in the personal allowance trap.
The pension contribution gets 60 per cent relief or, in other words, £10,000 into his pension costs him £4,000.
The cost appears to be cancelled out by the annual allowance charge, although he has £10,000 in a pension for an overall outlay of £8,000. In this instance, then, Lewis is 20 per cent up. If Lewis is a basic rate taxpayer in retirement this £10,000 contribution will net him £8,500 after 25 per cent of tax-free pension commencement lump sum and income tax.
The other factor to remember is that Lewis’s pension input into his GPP is £50,000 and his tax charge is £4,000. His adviser makes him aware that he can elect for the pension scheme to pay the annual allowance charge. By deciding to do this, he has £6,000 in his pension (as the scheme pays the money from his pension pot) for a £4,000 personal outlay.
His adviser emphasises that, even though the scheme will pay the annual allowance charge, he must still declare this on his tax return for the 2017/18 tax year.
Deliberately exceeding the annual allowance and triggering a tax charge may seem nonsensical. However, the important factor to remember here is that there is a net benefit to Lewis in doing so.
The same theory could have been applied if Lewis was in the same trap but had lifetime allowance instead of annual allowance issues. A 55 per cent lump sum lifetime allowance charge is worth the 60 per cent relief.
By taking this course of action, Lewis’s adviser has ensured he has reduced his tax bill and increased his future savings in a tax efficient manner.
Mark Devlin is technical manager at Prudential