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Pensions vs share schemes for higher rate taxpayers

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Wallace works for a large pharma-ceutical company and has net relevant earnings of £44,800 after factoring in his employer’s pension scheme, to which he is contributing the maximum matched amount.

He is due to meet his adviser for an end of tax-year review. Since his last review meeting, Wallace has changed jobs and his adviser has asked him to bring along information about all the employee benefit options available to him at the new company.

In the past, Wallace’s adviser has used pension contributions to mitigate his higher rate tax position. This year, the share incentive plan catches his eye.

The traditional approach

A total of £1,800 of Wallace’s salary falls into the higher rate tax bracket. From this, £720 of income tax will be deducted under PAYE as well as £36 National Insurance, giving Wallace take-home pay of £1,044.

If the £1,044 is then paid into a relief at source pension scheme, £1,305 will be added to the pension (after basic rate tax relief) and, as a higher rate taxpayer, Wallace will get a further £261 tax relief, which he can reclaim from HM Revenue & Customs. This means a £1,305 pension contribution will only cost Wallace £783 (£1,044 of net salary less the further £261 tax relief).

However, this approach still leaves £495 of his salary in the higher rate tax bracket, meaning he will pay £198 of tax to HMRC. The whole £1,800 is still liable for NI, so his £36 NI bill is unchanged.

If, in the future, Wallace removes this money from his pension pot, assuming no investment growth, as a basic rate taxpayer (after 25 per cent pension commencement lump sum) he will receive £1,109.25. Should he still be a higher rate taxpayer he will net £913.50.

This means that, for an initial net cost of £783, Wallace’s return on investment as a basic rate taxpayer would be 41.67 per cent and as a higher rate taxpayer 16.67 per cent, which makes the pension look like an attractive option.

Alternative course of action

After reading the share incentive plan information, Wallace’s adviser spots that for every four shares purchased in the plan his employer will contribute an extra share.

By directing Wallace’s excess salary to the share incentive plan instead of a pension, there is no deduction of tax or NI, so the full amount of £1,800 will be added to the plan. The cost of this to his take-home pay after tax and NI, as in the previous example, would be £1,044.

As Wallace’s employer is adding one share for every four he buys, this will add £450 to the share incentive plan. This means that, for a cost of £1,044 to Wallace, a total of £2,250 will be paid into the share incentive plan.

Using this option, again assuming no investment growth, would give Wallace a return on investment of 115.52 per cent compared with 41.67 per cent or 16.67 per cent, depending on his tax status at the time, from the pension.

This much higher return is because the share incentive plan uses the full £1,800 salary and, therefore, for the same cost to Wallace’s take-home pay, he is paying £234 less in tax and NI for the year compared with the pension option.

Pros and cons

While the personal contributions to a share incentive plan are limited to £1,800 per annum, they do offer compelling tax advantages. Contributions are paid to the plan before the deduction of income tax or NI. If they are held for five years then there is no income tax, NI or capital gains tax to pay when the shares are cashed in.

There are tax consequences if the shares are cashed in within five years but, as they are equity investments, they should not normally be considered short-term investments anyway.

Of course, not every employer will offer a share incentive plan and some may not offer additional shares. But for those who do have access, it is an option worth considering as part of their overall financial planning.

It is not without risk, though. If the member leaves employment within five years, their employer’s matching shares may be withdrawn (although there may be concessions if the client is made redundant or retires). There is also the “eggs in one basket” risk of investing in a single company’s shares.

However, after five years, the client may decide to extract the shares free of tax and invest the money in another tax wrapper – a pension or Isa, for example – which could then be invested in a way that provides more diversification.

Mark Devlin is technical manager at Prudential UK

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