Contributing to regain personal allowance

From the 2010/11 tax year individuals with ‘adjusted net income’ exceeding £100,000 had their personal allowance reduced.

This reduction is at a rate of £1 for every £2 of income over £100,000. Based on the current personal allowance, this means that any person with income over £125,140 will lose their full personal allowance.

When working out taxation of income, you start with the personal allowance, and then apply tax at the basic-rate band and then tax at the higher-rate band. If the personal allowance is removed because the client’s net adjusted income is £125,140 or above, this effectively adds to the individual’s tax burden as more income becomes taxable. The client now has no personal allowance and so is taxed on the £12,570 at their highest marginal rate.

So, the removal of personal allowance has increased the amount to tax paid by £5,028, i.e., 40% of the lost personal allowance.

If the client has an income exceeding £125,140 and still wishes to make personal pension contributions to reduce their income below the £100,000 threshold, this will produce a tax saving on what would have been paid if this course of action had not been taken.

This is only effective for contributions made via the relief at source method (this is making a net personal contribution into a personal pension when the provider will then increase this contribution up by the basic rate of tax).

The following illustrates the impact of paying a gross pension contribution via relief at source of £25,140 for an individual with income of £125,140.

Adjusted net income is defined in section 58 of the Income Tax Act 2007. Broadly it is the total income on which an individual is liable for tax, less the gross amount of any individual personal pension contributions, or third-party contributions (relief at source). However, remember that this is not the calculation for the actual payment of income tax and National Insurance (NI), and the full income before removal of the pension contribution will be subject to full tax and NI.

Other additional benefits of making a pension contribution

It is not just the personal allowance that can benefit from pension contributions, although this will generally take the highest interest. However, this same process can be used in other scenarios with similar beneficial effects.

Chargeable gains and CGT

The extension of the personal allowance can also create benefits for other financial planning elements, such as chargeable gain calculations on bonds or capital gains tax calculations on collective investments (funds). In both these circumstances, the pension contribution used for reclaiming the personal allowance will also be seen to extend the basic rate tax band for the use of bond top-slicing and capital gains. So, the use of a strategic pension contribution could reduce the tax rates down from 40% to 20% on bond gains and 24% to 18% on CGT. These links can provide further details of these events.  

• Chargeable events
• Capital gains tax

High-Income Child Benefit Tax Charge

Much in the same way as shown for the personal allowance, the introduction of a personal pension contribution made by the relief at source method can be used to reduce income down below the £60,000 threshold for repaying child benefit.

Personal pension benefits

In addition to giving a potentially tax advantageous position for the above scenarios – you should also remember the pension contribution itself.

• Outside of the client’s estate for IHT
• Immediate uplift by the basic rate tax band for the investment
• Tax free fund growth
• 25% of the fund available at retirement tax free.

So based on the above it can be seen that the use of a relief at source personal pension contribution can be potentially beneficial in many ways.