Should you make the most of increased pension allowances?

In his November 2022 autumn statement, chancellor Jeremy Hunt froze the income thresholds for basic and higher rate taxpayers. He also reduced the income threshold for additional rate taxpayers and froze income thresholds for national insurance payments. This means that, as we receive any future pay rises, more of us will fall into these tax bands and pay more income tax and national insurance.

In addition, as we show in our article How to reduce your capital gains tax liability, tax allowances are falling sharply on capital gains, referring to the profit made from an asset that has increased in value. Tax allowances are also falling steeply on share dividends.

In contrast, in the March 2023 budget, Hunt increased the tax-efficient annual pension allowance from £40,000 to £60,000 and effectively removed the tax charge on funds held in excess of the lifetime pension allowance limit of £1,073,100.

Consequently, we might consider putting more into a pension in order to bring down our overall tax burden. This article considers defined contribution (DC) pensions rather than defined benefit (DB) pensions. With DC pensions, contributions are made into a pension pot whose value is based on the contributions made and the investment performance of the pension. DB pensions are usually workplace pensions in which the pension income is based on your salary and how long you’ve worked for your employer.

But other tax-efficient vehicles, such as ISAs (Individual Savings Accounts), can also be used by people wanting to reduce their tax liabilities. Furthermore, people who have already used up their annual pensions tax allowance could consider investing in higher-risk tax-efficient vehicles, such as Venture Capital Trusts (VCTs) and Enterprise Investment Schemes (EISs). But these are only suitable for experienced investors who are able to accept the risk that they may lose all their money.

So, when it comes to reducing our tax burden, putting more into a pension may not be the right thing for everyone. Even so, it is something many of us may want to consider.

The way to make the most of the pension tax allowance is, quite simply, to pay more into a pension. Rules on pensions are fairly straightforward if your payments are well within HMRC’s contribution limits. But they can be quite complex if you’re close to or exceeding those limits, and I give only brief details in this article. If you want an exhaustive guide to the rules on tax relief on pensions, then the Money Helper website may be of assistance. It is run by a government organisation called the Money and Pensions Service, part of the Department of Work and Pensions.

You get tax relief on your pension contributions at the rate you pay income tax. And any pension fund growth is free of tax. For every £800 someone pays into a defined contribution pension, the government adds £200 basic rate tax relief; higher rate taxpayers get a further £200 of tax relief through their tax assessment; and additional rate taxpayers get a further £250 of tax relief.

This refers to the tax relief you receive when you pay into a pension, but tax is payable when you come to draw on your pension. Even so, 25 percent of pension withdrawals are tax-free and there is no national insurance to pay on pensions withdrawals.

Pension rules

For most of us, the amount we can contribute tax-efficiently into a pension is capped at a maximum £60,000 per year (this includes any contributions from our employer). But the amount we can contribute is also linked to what we earn. If we earn less than £60,000 then we can usually only contribute tax-efficiently up to our annual salary level.

People who have no earnings can generally put just £3,600 a year into a pension. But, due to pensions tax rules, non-earners only need to contribute £2,880 and HMRC will then add £720 of basic rate tax relief to bring the total contributions to £3,600.

Pension planning and child benefit

Some parents can also use pension planning to ensure they are eligible to receive child benefit. Child benefit is currently £24.00 a week for an eldest or only child and £15.90 a week for each additional child. But if one or other of the parents earns ‘adjusted net income’ of more than £50,000 a year, then child benefit may be reduced or eliminated altogether. Adjusted net income includes taxable benefits from employment, such as a company car or medical insurance.

But you can potentially reduce your adjusted net income by paying more into a pension, although the rules here are complex. Thankfully, the Gov.uk Child Benefit tax calculator can help you assess if you could be subject to what is known as the High Income Child Benefit Charge. It could also assist you in working out if increased pension contributions could potentially help you avoid or reduce this charge.

Pensions and personal allowance

Moreover, as we show in our Pensions and your personal allowance article, people earning more than £100,000 can be hit with an effective 60 percent tax rate. This is because HMRC claws back the annual personal allowance of £12,570 for income above £100,000. Once again, you could potentially reduce your tax liability by paying more into a pension.

Carry forward

If you haven’t contributed the maximum amount to your pensions in the previous three years, then you may be able to use something called ‘carry forward’. This allows you to make pension contributions that exceed your annual allowance up to the unused relief amount brought forward and still benefit from tax relief. Note that tax relief is still based on what you earn in the current tax year.

High earners should be mindful that, once they earn more than £200,000 a year, then the amount they can pay into a pension tax-efficiently could reduce. Our article on Tapered pension allowance for high earners provides more information on this.

The total amount you can invest tax-efficiently in a pension throughout your lifetime (the lifetime allowance) was usually £1,073,100. Pension savings above this level were generally subject to tax. But Hunt’s effective removal of the lifetime allowance means there is now no limit on the amount of pensions savings you can build up tax-efficiently.

Maximising pension allowances involves making sure you know what your available allowances are and what your unused allowances are. If you have the capacity to invest the maximum annual allowance, then there may be benefits in doing so.

Look at the bigger picture

While the £1,073,100 lifetime allowance has been effectively removed for pension savings, it still has a place for pension withdrawals. Broadly speaking, when you come to draw on your pension, you can withdraw 25 percent of it tax free. But this is capped at 25 percent of £1,073,100, which amounts to £268,275.

So any withdrawals above 25 percent of the pension value or above £268,275 would be subject to tax. However, some pension holders with relevant protections in place due to previous allowances may be able to withdraw 25 percent tax free even if that value is over £268,275.

In the end, pensions are an attractive vehicle for reducing our tax liabilities at a time when tax-efficient opportunities are dwindling. But working out whether and how much you should put into a pension is an important decision and often a complex one. A good financial adviser can take a holistic view of your finances and assess how investing in a pension could potentially work for you.

Financial advisers with a firm grasp of market developments and of the tax regime can throw light upon more complex investments and options. And they can help you grasp the potential outcomes of financial decisions. Hence, at Schroders Personal Wealth, one of our key principles is to conduct regular reviews with advisers.