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Paying 40% tax? Reduce the impact by claiming pension tax relief
We're taxed 40p for every pound we earn over £50,270. And more of us are getting caught in this 40% higher rate tax bracket by stealth. Wages are rising, but the tax threshold has been frozen until 2028.
According to the Institute of Fiscal Studies (IFS), by 2027-28, 14% of us will be paying the 40% higher rate of tax1.That compares with just 3.5% of adults in 1991-92. Some teachers and nurses are now even caught in this higher tax bracket.
A promotion can seem barely worth the effort if it pushes us over the tax threshold.
However, all (money!) is not lost thanks to pension tax relief.
Tax efficient pensions
If you can afford it, increasing your personal pension contributions can keep more of your earnings under the higher rate threshold.
And once you're subject to higher tax rate, you do get more generous pension relief from HMRC – an additional 20%. This can go some way to offsetting the impact of 40% tax on your earnings.
Importantly (and frustratingly), depending on your pension scheme, you will have to file a self-assessment tax return to benefit from this additional tax relief.
This example explains the impact tax relief could have on your pension.
John’s had a pay rise, taking his salary from £48,950 to £52,270.
As John now earns £2,000 above the higher rate tax threshold, he has to pay 40% tax on this £2,000, which is £800.
Meanwhile, John continues to pay 5% gross into his workplace pension. This means his personal contribution, plus basic tax relief (at 20%) was £2,447.50 a year for his previous salary and will naturally increase to £2,613.50 based on his new salary. In addition, his earnings now take him over the higher tax threshold, meaning he can claim an additional 20% tax relief on his pension contributions, equivalent to £522.70. He could get HMRC to offset it against taxes paid, add this money to his pension once he’s claimed it, or use it as disposable income.
In effect, the £800 subject to 40% tax has been offset by more than £500 in pension contributions tax relief.
Claim that pension tax relief!
Importantly, if your workplace pension scheme is a 'relief at source' scheme, you MUST claim the additional 20% in tax relief via a self-assessment tax return2 to HMRC within four years.
Many of us are unaware of this additional tax relief or haven't got round to claiming it. Shockingly, around eight in 10 higher-rate taxpayers3 eligible between 2016-19 failed to do a self-assessment, missing out on around £810 million in unclaimed payments!
If you're part of a Netpay scheme, you'll already get the full tax relief and don't need to do anything. So, how do you know if you're 'relief at source' or Netpay4? If your pay slip indicates that tax relief has been added on your personal contribution, this is a 'relief at source' pension scheme. If it only states 'employer contribution,' it is more likely a Netpay arrangement.
Earning more than £100,000?
The 40% tax rate applies to anybody earning between £50,271 and £125,140 (you'll be taxed at 45% for anything over this amount). However, when your income surpasses £100,000, your yearly personal tax-free allowance (£12,570) begins to fall, which could make the tax you're paying equivalent to 60%! However, you may be able to add more money to your pension plan to protect this basic tax-free allowance.
I can help your pension work harder for you. To discuss your situation in more detail, contact me for a no-obligation meeting. And if you want more tips on managing your money better, take a look at my other financial planning articles.
The value of an investment with St. James's Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up. You may get back less than you invested.
The levels and bases of taxation, and reliefs from taxation, can change at any time. The value of any tax relief is generally dependent on individual circumstances.
1 Institute for fiscal studies, published 16 May 2023
2 www.gov.org.uk Tax on your pension contribution
3 www.pensionage.com from 18/10/2021 Unclaimed pension relief
4 www.moneyhelper.org.uk Tax relief on pension contribution from 2024
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