Pension contributions - higher rate taxpayer - how does this work?

littleangel

After some much needed tough-love advice from this site (thank you!) I've removed my head from the sand and started contributing to my pension at the age of 31.

But I'm now very confused - a recent pay rise has tipped me into the higher rate tax bracket, so I'm using the amount that's in the higher rate tax bracket to pay into my pension. I got the impression that if I put 60 pounds in, that would equate to 100 pounds into my pension fund, but apparently they take my post-tax income and add 22%. How do I get the extra 18%?

Sorry, this is a stupid question, but not having done this before, I assumed that I could nominate a pre-tax amount which would go straight into my pension fund so effectively it would be like getting the extra 40%. But it doesn't appear to work like that...

Can anyone explain how this works?

Also, general advice welcome - my company pays 5% of my salary into my pension, and my additional contrbutions are about 5% as well - is this sufficient for a decent pension or should I be looking to contribute more?

Tel_4

Hi,

hope this helps.

Firstly, you are entitled to tax relief at your "marginal rate" which in your case is 40% as your earned income takes you into the higher rate tax bracket.

When you make a pension contribution, tax relief is given on your contrbution, but only at the basic rate which is currently 22%.

This doesn't mean that you are not entitled to the additional 40% tax relief. It just means that you dont get it "up front"

You can claim the additional tax relief via your self assessment tax return.

Pension contributions for higher rate tax payers such as yourself are extremely tax efficient. For every £1.00 you pay, the Govt pays 40p.

Dont forget though, when you come to buy an annuity (a pension income from your fund) that the Govt will tax this income as "earned income" so if you are still a higher rate tax payer at this time, you pay tax at 40%

The contributions that you pay into your pension "grow" without any liability to income tax (almost but I wont bore you with the details) or capital gains tax. This means that your fund should over time, outperform a fund that was subject to tax.

Your question re "am I paying enough" is a difficult one to answer.

This depends on:

1) When do you expect to retire?

2) What income do you want in retirement? (Eg two thirds of your current income?)

3) Do you have any non-pension assets? (Eg expected inheritances savings accounts ISA'S PEPS unit trusts etc etc)

4) Do you have a deferred pension from a previous employment?

5) What is your "attitude to investment risk" We all want our pension fund to grow, but in reality this can only be achieved over the longer term 20-25 years by investing in higher risk equities as well as cash or fixed interest funds.

6) Pensions are converted into income at retirement by buying an annuity and the amount of income you get depends on annuity rates. The fact is that we are all living longer (on average) and annuity rates are falling. Think about it for a minute. Instead of living on average until age 73, (now) if you retire at age 60, your life expectancy may be 88! This means that your annuity will have to pay you an income for longer. The result is that your pension fund will buy you a smaller initial annuity because it has to be paid for a longer time period.

The sad fact is that this country is a ticking time bomb when it comes to pensions.

Most of us want to retire early, yet have inadequate pension income to replace earned income from employment.

Cheers,

T.

dunstonh

If you claim childrens tax credits, you also need to make them aware of your pension contributions as these in effect lower your income and can boost the amount of childrens tax credit.

rockrat

ok, now i am a little concerned as i have never bothered to look into the tax implications of pensions.
a little clarification in simpleton terms for me would be most appreciated.
I, like littleangel am a 40% taxpayer, 32 years old and the company pay around 5% salary into a pension fund. I make voluntary payments of only £60 a month, but thats every month. This has been going on now for about 3 years.
I have never filled in any tax forms of any kind and simply rely on my new tax code arriving every year. the fact that i have not been filling in forms, does this mean the goverment are not providing me any tax relief?
the company use an outside pensions advisor and i always assumed that they dealt with these elements, i should know better really.

Also we do recieve a very small amount of childrens tax benefit as we have 2 small kiddies, is it true we could possibly increase this by showing we have a reduced income due to pensions payments, although i really dont think £60 payments will make much difference

all comments appreciated

dunstonh

The company contributions are irrelevent. Ignore those. Your personal contributions, if taken from the payslip are irrelevent as they should be deducted from the payslip before tax. If you make a direct debit contribution then you need to declare your contributions on your tax return to get the extra tax relief.

Tax credits need to be aware of your income after personal gross contributions are deducted. Some older threads in here describe how in effect, you can get up to 72% tax relief through higher rate tax rebate and tax credit increase.

littleangel

Thanks guys!

Tel wrote:

When you make a pension contribution, tax relief is given on your contrbution, but only at the basic rate which is currently 22%.

This doesn't mean that you are not entitled to the additional 40% tax relief. It just means that you dont get it "up front"

You can claim the additional tax relief via your self assessment tax return.

...and it gets more complicated!!! So I need to fill in a tax return each year now? And does the government send me back the 18% in cash or does it go onto my tax code?

In terms of how much I should be paying, to answer your questions, Tel, I'll probably be working for another 30 years, and 2/3 of my current income should be plenty (given that 1/3 goes on the mortgage at the moment which won't be an issue then). I've got no other real savings at the moment, just a 6 month "emergency fund" in ISAs, and no other pensions.

Tel_4

Hi,

30 years....not much when you say it quicK!!!

Not sure how your additional 18% tax relief will be paid, but your tax office will be able to tell you.

OK, so your goal is to achieve an income in retirement of two thirds of your final salary.

A few assumptions are necessary.

What will your final salary be in 30 years??

Lets assume that you stay in your current job, and dont get promotion (I am sure you will!)

We need to assume that your salary will increase each year. Historically, annual National Average Earnings have increased at a higher rate than inflation, so, lets assume an annual salary increase of 3.5% if we assume that inflation will increase each year by 2.5%.

I dont know what your current salary is, so I will let you do the sums.

Hopefully we now have a final salary figure.

OK, your target is a pension of two thirds of this figure.

I presume that both you and your employer are paying into a Personal Pension Plan.

I dont know what the current value of your plan is, so I cant calculate the pension fund that you may get at retirement.

What you can do, is ask your Personal Pension Provider for a projection of what your pension will be at your selected retirement age of 62. They will be able to do this assuming that your pension contribution stays the same, and should also be able to project a figure assuming an increase in your contribution say by 5% a year.

The projection will add your future contributions onto your current fund value, take off the pension providers charges, and assume an investment growth rate of 5% 7% and 9%.

It will then convert your projected fund to an annuity using an assumed annuity rate. All pension providers have to use the same % projection growth rates and assumed annuity rate.

This now gives us a pension income.

You can compare this to your final salary calculation that you performed earlier on.

Surplus income? Shortfall?

Please remember that investment growth rates are not guaranteed, they are only illustrative as is the assumed annuity rate.

Annuity rates have been falling now for a while.

One of the main reasons for this is that on average we are living longer. (For every 10 years that go by we are living 3 years longer). This trend is expected to continue, what with advances in medical science and us having healthier lifestyles (in theory anyway!).

So, if we are living longer, that means the Insurance Company that provides the annuity has to pay the annuity income for longer. result- a lower initial income.

I have assumed that you only have this one Personal Pension Plan, but if you have any other pension income, from say other Personal Pension Plans you will need to perform a similar excercise.

If you have a "deferred" pension from a final salary occupational scheme relating to a previous employment, the calculation is a little trickier so let me know on that.

Hope this helps.

ps. Dont be surprised if there is a big difference between your target income of 2/3rds of your final salary & the projected income from your PPP.

Several million other people are in the same boat as you....

Tel.

Debt_Free_Chick

So I need to fill in a tax return each year now?

You'll prbably have to anyway if you're a 40% taxpayer e.g. to pay extra tax on any interest on savings.

However, don't wait for the end of the tax year re your pension. Phone your tax office and get form PP120 as this is the claim for extra tax relief on your pension contributions.

And does the government send me back the 18% in cash or does it go onto my tax code?

On your tax code, initially, until you complete your tax return at the end of the year. But remember, that a credit on your tax code results in more pay in your pocket, as you pay less tax :-)

Pal

Tel wrote:

Pension contributions for higher rate tax payers such as yourself are extremely tax efficient. For every £1.00 you pay, the Govt pays 40p.

Being the picky sort, this should actually have said:

"Pension contributions for higher rate tax payers such as yourself are extremely tax efficient. For every 60p you pay, the Govt pays 40p."

In the end it depends whether your £1 contribution was from pre or post tax income.

Just to clarify the position re the tax relief:

If you an employee and the pension contributions are deducted from your pay packet, then you get immediate tax relief. The pension contributions are deducted from pre-tax earnings before you pay income tax. You do not need to complete a tax return to claim back this tax as you are given it immediately.

If you are paying into a personal pension, stakeholder or free standing AVC plan you are paying from net income, the provider will immediately claim back 22% of the tax you have already paid on your contribution. To get the remaining 18% you need to complete a self assessment tax return.

Personally I recommend anyone in the 40% tax bracket contacts the revenue and asks them to send a self assessment form asap to complete. The IR will catch up with you eventually and will simply send you all past returns to complete, covering the entire period that you were a higher rate taxpayer. I failed to do this and had to complete four tax returns at once, which was a paperwork nightmare!

And all to prove that I owed about £10 in tax.

Debt_Free_Chick

Being the picky sort, this should actually have said:

"Pension contributions for higher rate tax payers such as yourself are extremely tax efficient. For every 60p you pay, the Govt pays 40p."

To continue the pickiness, it's not really tax "relief" but tax deferral. Ignoring the tax-free lump sum, you'll pay income tax on the pension generated by your contributions. So if you're in the 40% tax bracket in retirement, then you've not had tax relief at all.

To get the remaining 18% you need to complete a self assessment tax return.

Yet more pickiness ...! If you're a 40% taxpayer, you should have completed and returned last year's SA form already. Better to get Form PP120 which will correct the position now, going forwards and then do the catch up on this year's SA Form.

Nothing like the prospect of the taxman handing over money to motivate you to complete the return early!

DFC
Who got her refund from the taxman on 9 May last year

dunstonh

To continue the pickiness, it's not really tax "relief" but tax deferral. Ignoring the tax-free lump sum, you'll pay income tax on the pension generated by your contributions. So if you're in the 40% tax bracket in retirement, then you've not had tax relief at all.

In the season of pickiness we now have....

You gain a full 40% relief on all your contributions. (ignoring those that are borderline higher rate tax payers and ignoring any gain in childrens tax credit)

If you retire at 65, you are able to earn £6830 pa with no tax deduction, followed by £2020 at 10% tax and then £29380 at 22%. Then you enter the 40% tax band. (at age 75, the personal allowance increases a little more).

So not all the income would be at 40% and therefore it isnt really tax deferral.

A couple should look at their retirement planning to make sure that each personal allowance is used so that tax free band is not wasted.