For the 2011/2012 tax year, the basic-rate and higher-rate income tax limits in most cases will be £35,000 and £150,000 respectively and income above these levels would usually be taxed at the higher rate and additional rate (40 per cent and 50 per cent respectively).
The payment of a pension contribution can extend an individual’s basic and higherrate tax limits, resulting in a smaller liability to higher or additional rate tax.
Before calculating any tax relief, we need to determine the amount of the gross contribution, which would normally involve grossing-up the net amount paid by the basic-rate tax relief given at source. The amount of the gross contribution is then added to the basic-rate tax limit and, if applicable, the higher rate limit.
For example; an individual (let’s call him John) makes an £8,000 contribution to his personal pension which is grossed-up to £10,000 by basic-rate tax relief. £10,000 is therefore added to his basic-rate tax limit, giving an extended limit of £45,000.
If John has taxable income of £43,000 (after deducting the personal allowance of £7,475) the effect of this is that where some of his income would previously have been subject to higher-rate tax , after making the pension contribution, all his income now falls within his extended basic-rate tax limit. This saves John £3,600 in tax (£2,000 basic rate tax relief at source plus £1,600-£8,000 at 20 per cent). Now if an individual can combine making this payment with the chargeable gain arising from the encashment of a single premium bond, the tax saved can be increased.
Assume another person (let’s call this one Pauline) is a higher-rate taxpayer with taxable income of £40,000 (after deducting her personal allowance). Pauline encashes a UK single-premium bond which results in a chargeable gain of £67,475. The bond had been held by her for 10 years. As she is a higher-rate tax-payer, her tax liability on the bond will be 20 per cent of the chargeable gain (£13,495).
Unfortunately for Pauline, owing to the level of her income, she cannot make use of top-slicing relief. Indeed, with the level of her total income and the amount of the chargeable gain, she will also lose the benefit of her personal allowance as her adjusted net income exceeds £100,000.
The personal allowance is reduced by £1 for every £2 in excess of £100,000 until it is eliminated where total income exceeds £114,950. The effective rate of tax on income in this range is 60 per cent.
However, if Pauline pays a gross contribution of £14,950 to a pension she would recover the availability of the personal allowance. This would also extend her basic-rate tax limit from £35,000 to £49,950 which would mean that top-slicing relief becomes very important to her. With the bond having been held for 10 years, the top-sliced gain is £6,747. Owing to the pension contribution made, the whole of the top-sliced gain now falls within Pauline’s enhanced basic-rate tax limit, meaning that there will be no tax pay-able on the top-sliced gain.
The tax relief stands at a massive £20,475 (£3,990 saved by recovering the personal allowance and reducing the income tax liability, £13,495 saved on the chargeable gain plus £2,990 basic-rate tax relief at source derived from the net contribution paid of £11,960). So in these circumstances, the tax saved more than covers the net pension contribution.
The key is to pay a high enough contribution to the pension to move the top-sliced gain from being subject to higher rate tax to below the extended basic rate tax limit and to recover the availability of the personal allowance. For some clients, very significant tax savings can be made.
Brian Murphy is financial planning manager at Axa Wealth