Can someone please explain why HMRC calculate income tax on pensions like this?

Pythagorous

I'm doing my self assessment and struggling to understand why HMRC seem to be calculating tax on my pension contributions. I'm obviously missing something very simple and would be grateful if someone could explain!

Using fictional figures here for simplicity:

• Total Income after netting off work pension payments = £58,270
• Amount paid into personal pension (SIPP) from my net salary = £7K. Note, the SIPP provider (Vanguard) topped this up automatically to 7K/0.8=£8,750 (since it was paid from post tax income).

My calculation of what income tax should be:

• £0 on the first £12,570 due to Tax free allowance
• £7,540 tax on the next tranche of income up to £50,270 which is taxed at 20% (i.e., (50,270-12,570)*20%=7,540)
• That leaves income of 58,270-50,270=£8K to be taxed at 40%. However, netting off the 7k I paid into the SIPP (which shouldn't be taxed) I calculate my 40% tax liability to be (8k-7k)*40%=£400.

My calculation of the total tax liability: £0+£7,540+£400=£7,940

However HMRC seem to calculate the tax liability as follows:

• £0 as per above up to tax free annual allowance of £12,570
• Instead of taking the personal pension payment off they instead say the basic rate gets increased by 7K/0.8=£8,750 to £46,450 (50,270-12,570+8,750). They then say that my remaining income after taking off the tax free allowance (but without taking off the personal pension payment I made to the SIPP) should all get taxed at 20% (which is within their new basic rate limit of £46,450). Hence their calculation looks like this: (£58,270-£12,270)*20%=£9,254. This is obviously significantly higher than my calc above and also to my mind it means that my personal pension contribution is being taxed at 20%?

Grateful if someone could explain the flaw in my calc and help me understand! Thanks!

BoGoF

Payments into a SIPP extend your basic rate band by the gross amount. It is not a deduction from taxable income - not sure where you get that idea from.

Dazed_and_C0nfused

Pythagorous said:

I'm doing my self assessment and struggling to understand why HMRC seem to be calculating tax on my pension contributions. I'm obviously missing something very simple and would be grateful if someone could explain!

Using fictional figures here for simplicity:

• Total Income after netting off work pension payments = £58,270
• Amount paid into personal pension (SIPP) from my net salary = £7K. Note, the SIPP provider (Vanguard) topped this up automatically to 7K/0.8=£8,750 (since it was paid from post tax income).

My calculation of what income tax should be:

• £0 on the first £12,570 due to Tax free allowance
• £7,540 tax on the next tranche of income up to £50,270 which is taxed at 20% (i.e., (50,270-12,570)*20%=7,540)
• That leaves income of 58,270-50,270=£8K to be taxed at 40%. However, netting off the 7k I paid into the SIPP (which shouldn't be taxed) I calculate my 40% tax liability to be (8k-7k)*40%=£400.

My calculation of the total tax liability: £0+£7,540+£400=£7,940

However HMRC seem to calculate the tax liability as follows:

• £0 as per above up to tax free annual allowance of £12,570
• Instead of taking the personal pension payment off they instead say the basic rate gets increased by 7K/0.8=£8,750 to £46,450 (50,270-12,570+8,750). They then say that my remaining income after taking off the tax free allowance (but without taking off the personal pension payment I made to the SIPP) should all get taxed at 20% (which is within their new basic rate limit of £46,450). Hence their calculation looks like this: (£58,270-£12,270)*20%=£9,254. This is obviously significantly higher than my calc above and also to my mind it means that my personal pension contribution is being taxed at 20%?

Grateful if someone could explain the flaw in my calc and help me understand! Thanks!

You seem to have totally misunderstood how RAS pension contributions work.

They never reduce your taxable income.

They increase the amount of basic rate tax you can pay, this reducing the amount charged at higher rate.

Plus you get the basic rate relief in your pension fund.

So in a very simplistic example you have made a gross contribution of £8,750 of which £1,750 was pension tax relief.

Your basic rate band is extended by £8,750 meaning (if you have enough non savings non dividend income) an extra £8,750 is taxed at 20% instead of 40% making a personal tax saving of £1,750.

Overall result is £8,750 pension fund which has cost you £5,250 😀

Pythagorous

BoGoF said:

Payments into a SIPP extend your basic rate band by the gross amount. It is not a deduction from taxable income - not sure where you get that idea from.

Ah okay, so that's where I'm wrong. Thanks! So does that mean I would have been better off putting these SIPP payments into my work AVC scheme instead (all other things being equal) given they would have acted as a deduction from taxable income?

BoGoF

Pythagorous said:

BoGoF said:

Payments into a SIPP extend your basic rate band by the gross amount. It is not a deduction from taxable income - not sure where you get that idea from.

Ah okay, so that's where I'm wrong. Thanks! So does that mean I would have been better off putting these SIPP payments into my work AVC scheme instead (all other things being equal) given they would have acted as a deduction from taxable income?

Unless it was via salary sacrifice then no. The net result is the same in that you get 40% tax relief either way.

Dazed_and_C0nfused

Pythagorous said:

BoGoF said:

Payments into a SIPP extend your basic rate band by the gross amount. It is not a deduction from taxable income - not sure where you get that idea from.

Ah okay, so that's where I'm wrong. Thanks! So does that mean I would have been better off putting these SIPP payments into my work AVC scheme instead (all other things being equal) given they would have acted as a deduction from taxable income?

Yes.  But only in as much as you would for the tax saving immediately via reduced PAYE deductions, the end result would almost certainly be the same tax wise.

You might feel worse off if the AVC doesn't offer your preferred choice of investments or has higher fees than your SIPP.

Pythagorous

Dazed_and_C0nfused said:

You might feel worse off if the AVC doesn't offer your preferred choice of investments or has higher fees than your SIPP.

Thank you! I'm assuming it's always possible to transfer AVCs out to a SIPP.

Johnjdc

BoGoF said:

Payments into a SIPP extend your basic rate band by the gross amount. It is not a deduction from taxable income - not sure where you get that idea from.

Probably from people doing it to reduce their "Adjusted Net Income" to avoid the 60% rate between 100k and 125k?