Maximising 40% tax relief on pension contributions

MarkPC

Thanks for taking the time to explain Jem - much appreciated. Think I understand now - although can't say I like it!

Oh well at least I can update my tax details properly now. Thanks again - you did a better job than than the HMRC call centre.

jem16

MarkPC wrote: »

Thanks for taking the time to explain Jem - much appreciated. Think I understand now - although can't say I like it!

I'm not exactly sure what you don't like about it.

If you earn £100 as a higher rate taxpayer you will pay £40 in tax.

If you pay £100 into a pension you get £40 tax relief - £20 via the provider claiming and £20 via you claiming.

So exactly the same in tax relief as the tax paid.

peterxyz

jem16 wrote: »

I'm not exactly sure what you don't like about it.

If you earn £100 as a higher rate taxpayer you will pay £40 in tax.

If you pay £100 into a pension you get £40 tax relief - £20 via the provider claiming and £20 via you claiming.

So exactly the same in tax relief as the tax paid.

Jem,

The issue which Mark is highlighting is as follows:
Salary Sacrifice: If you contribute gross £100 as a higher rate taxpayer you will pay £40 less in tax. (net cost of contribution £60)

After-tax Lump Sum: If you contribute £60 as a higher rate tax payer:
pension scheme grosses it up for basic rate tax: £60/0.8 = £75
HMRC gives you a credit at the same rate: £15
total value £90

I have to admit that I'm somewhat confused by the situation myself.

peter xyz

hugheskevi

Salary Sacrifice: If you contribute gross £100 as a higher rate taxpayer you will pay £40 less in tax. (net cost of contribution £60)

Agreed - there is also a National Insurance saving, so the net cost is a bit less, but let's not complicate things.

After-tax Lump Sum: If you contribute £60 as a higher rate tax payer:
pension scheme grosses it up for basic rate tax: £60/0.8 = £75
HMRC gives you a credit at the same rate: £15
total value £90

In this example, you have £75 (£60 plus £15) in the pension pot at a cost of £45 (£60-£15).

Try sending £80 to the pension provider - they gross it up to £100 (£80/0,8), then HMRC gives you a credit of £20. So you have £100 in the pension pot at a cost of £60 (£80 less the £20 credit).

jem16

peterxyz wrote: »

I have to admit that I'm somewhat confused by the situation myself.

peter xyz

Hugheskevi has already given you the worked example but basically both you and Mark are starting from the wrong end. You must always think of tax relief on pensions from the gross amount and not the net amount.

Linton

MarkPC wrote: »

Thanks for replies. The bit which got me started on this was from the HMRC website:

"You pay Income Tax on your earnings before any pension contribution, but the pension provider claims tax back from the government at the basic rate of 20 per cent. In practice, this means that for every £80 you pay into your pension, you end up with £100 in your pension pot. If you pay tax at higher rate, you can claim the difference through your tax return or by telephoning or writing to HMRC."

The ambiguous bit for me is what is meant by 'the difference'. In terms of the tax actually paid by a higher rate payer this is not another 20% of £100 using the example above. But (£80/0.6)-100.

Does anyone know if the HMRC have clarified that the maximum gross amount is limited to basic rate rax band and it is assumed threrefore that the 40% is on this smaller figure?

It doesnt work like that. What happens is that everything is calculated from scratch - ie your gross pay is £x, the gross paid into a pension is £y, therefore your taxable pay is £x-£y-allowance. The taxable pay is then used as a basis for the tax calculation which is compared with the tax you actually paid. HMRC refund or charge you the difference.

thenudeone

In practice, the extra tax relief is given by increasing your basic rate band (from c. £35000) by £1 for every £1 (gross) that you put in your pension, so that for that amount of income, you are taxed at 20% which matches the amount your pension scheme reclaims at 20%.

This comes to the same answer as giving you the extra tax relief separately as a lump sum, as demonstrated below

Pension contribution
£5000 gross
£4000 cheque given to pension scheme
£1000 reclaimed by pension scheme
for a 40% taxpayer, an additional £1000 tax reduction is due

ALTERNATIVE 1 - give extra tax relief separately
Income £50000
First £7500 (say) 0% tax
Next £35000 20% tax - £7000
Remaining £7500 40% tax -£3000
Total tax paid £10000
LESS £1000 tax relief
NET TAX PAID £9000

OPTION 2- add pension payments to basic rate band
Income £50000
First £7500 (say) 0% tax
Next £35000 + £5000 = £40000 20% tax - £8000
Remaining £2500 40% tax - £1000
Total tax £9000

The total tax paid is the same in both cases.

EDIT: The above is how the calculation appears on your assessment (i.e. after you submit a tax return). The way it's corrected in PAYE is more complicated because they have to work out how much extra zero rate band to give you to have the same effect. a different BR band can't be included in a tax code.
Since (nearly?) everyone on HR tax completes a tax return, the PAYE adjustment isn't that important because an assessment will be completed anyway.

dreamon100

Hi, does this tax relief only apply to private pensions or to ones ran by an employer as well ?

jem16

dreamon100 wrote: »

Hi, does this tax relief only apply to private pensions or to ones ran by an employer as well ?

Tax relief applies to all pensions.