In the fifth part of our series ‘52 Ways to Save Tax’ we look at a way that you can both save tax and help prepare yourself financially for the future. Keep reading to find out how topping up your pension can help you pay less tax.
52 Ways to Save Tax – Part 5 : Top Up Your Pension
When you pay into your pension you receive tax relief from HM Revenue & Customs (HMRC). And, over time, the effect of this tax relief on your pension can be significant. There are three main ways that paying into your pension can be tax efficient:
1. Tax relief
When you pay into a pension you get tax relief on your premiums. The way this works depends on whether it is a company or a personal pension and we look at this further below.
2. Tax-efficient growth
Your pension fund grows largely tax-free, which can help to boost the amount you have saved in your fund.
3. Tax-free cash
When you take your pension benefits you can usually take up to 25 per cent of the fund as a tax-free lump sum (depending on your pension scheme rules). The remainder of your benefits will be paid as a taxable income.
If you pay more into your company pension you will pay less tax. If you have an occupational/company pension, your employer deducts your pension payments from your pay before working out your tax.
So if you earn £40,000 a year and pay an extra £1,000 a year into your pension, then only £39,000 will be regarded as ‘taxable pay’. The effect is that you pay £200 a year less tax.
If you are a higher rate taxpayer the tax savings can be even greater. For example, if you earn £45,000 a year and pay £1,000 a year into your pension you would pay £400 a year less tax. This effectively means that a £1,000 pension contribution has only cost you £600.
If you are self-employed or you are not a member of an occupational scheme, then you get tax relief in a different way when you pay into a personal pension. Any contribution to your pension gets a top-up to take account of basic rate of tax.
For example, if you pay £80 to your pension your pension provider claims back £20 tax on your behalf and adds it to your pension. Your total contribution is £100 but you only pay £80 of it yourself.
If you are a higher-rate taxpayer then you can claim the extra relief through your tax self-assessment form at the end of the tax year.
Limits on your tax relief
You can get tax relief on every penny you contribute to your pension, up to 100 per cent of your annual earnings, with an upper limit of £40,000 in 2014/15.
If you exceed this ‘annual allowance’ you may be liable to a tax charge and must tell HMRC through your tax return. However you may be able to ‘carry forward’ unused allowance from up to three years earlier.