Paying into a pension after rerirement to avoid 40% tax

dosh37

Because of higher savings interest rates last year, the frozen personal allowance and frozen savings allowances it is likely my total income this year will exceed the 40% threshold.

I have read that one possible way to avoid the higher rate threshold is to pay money into a pension. However, I am not convinced that would help in my case.

Since I am already retired and have no source of income apart from pensions and savings interest, the tax free limit of £2880 (net) would apply.

There are also recycling rules that may apply since I have already drawn 25% tax free from my pension pots.

Lets say I leave £2880 in my savings and it earns 4.5% interest. After 1 year it would be worth £2880 + £129 = £3009. If I am above the 40% threshold at that point, the income tax due on the interest could be £51.

Instead I pay £2880 from my savings into a pension and that now brings me below the 40% threshold. No tax would be due on the pension contribution, so I have saved £51.

The govt adds 20% making £2880 + £720 = £3600. (I assume this would be more if I am above the 40% threshold?).

After 1 year I draw down £129 from the pension. Assume I am now below the 40% threshold. The pension income would be taxed at 20% i.e. £25. Overall I have saved £26 compared to leaving the cash in a savings account subject to 40% tax.

The problem comes when you consider what happens some time later when the total £3600 - £129 = £3471 invested in the pension is eventually drawn.

Ignoring any gains from pension share investments, I would eventually end up paying 20% tax on the full £3471 capital amount i.e. £694.

That would not happen if I left the cash in my savings account because only the interest is taxed.

I seem to end up paying more tax by putting savings into a pension. The money is being taxed twice - once when it was first earned and again when the pension pot is eventually drawn. Is this correct or am I missing something?

Albermarle

The govt adds 20% making £2880 + £720 = £3600. (I assume this would more if I am above the 40% threshold?).
HMRC actually add 25% if you do the maths.
Then you would need to inform HMRC of your gross pension contribution ( £3600), they will use this in their annual tax calculation, which would reduce your 40% tax liability to 20% for that amount. So you would then get a rebate of £720.

The fact you are missing is that when you withdraw the pension you get 25% tax free.

TheSpectator

Think you are forgetting the 25% tax free element of any withdrawal. But generally you are correct there is less benefit if you are fortunate enough to be a 40% tax paying pensioner.

You don"t mention an ISA, do you have one for tax free interest?

RogerPensionGuy

The links below maybe helpful. 

Using small pots X 3 rules, I think its just possible to eek some fine financial housekeeping.

And must remember pension rules will probably keep changing and just maybe topping up pensions may work out well down the road. 

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https://www.gov.uk/tax-on-pension/tax-free#:~:text=A pension worth up to,sums from different workplace pensions

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https://professionalparaplanner.co.uk/benefits-of-small-pots-lumps-payments/

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dosh37

TheSpectator said:

Think you are forgetting the 25% tax free element of any withdrawal. But generally you are correct there is less benefit if you are fortunate enough to be a 40% tax paying pensioner.

You don"t mention an ISA, do you have one for tax free interest?

You are right.

So I could eventually draw £3471 * 0.25 = £867 tax free.

The remaining £2603 would be taxed at 20% =  £520 (assuming I am no longer in the 40% tax bracket).

I still lose out long term unless the pension share investments do exceptionally well.

I guess this is a good reason not to hold large amounts of cash savings: You have no control over when tax is due on the interest. If some of the money is invested in a mix of shares then you can decide if and when to sell and you can use your capital gains tax allowance. With hindsight I think I should have bought a more expensive house.

My ISA allowance is maxed out so that is not an option.