It’s no secret that people’s finances are creaking under the weight of a giant tax burden.
We are on course for tax revenues to hit the highest level, relative to the size of the economy, since the 1940s, according to the Office for Budget Responsibility.
Around 2.4 million people will be pushed into a higher tax bracket this year, with another 4.2 million set to pay tax for the first time, the Centre for Economics and Business Research calculated.
Even the record-breaking state pension rises are being eroded, with half a million more retirees snared by the stealth tax trap this year alone.
The reason we are all paying more tax is the freeze on income tax thresholds, which haven’t risen since 2021-22 and will remain there until at least April 2028. Known as “fiscal drag”, the freezing of both the personal allowance and the higher-rate threshold means that when pensions or pay increase, a sizeable portion finds its way back to the taxman.
But there are ways to beat the tax trap – and it all starts by using your pension.
Why pensions are so good at cutting at your tax bill
In the 2023 Budget, Chancellor Jeremy Hunt made two important changes to pensions. First, he removed the charge on the Lifetime Allowance, which was then abolished in April 2024. Previously, there was a £1,073,100 cap on the amount you could save into a pension without paying a tax charge.
Before the change, high earners like doctors were declining work and retiring early. Now that’s gone, it has become worth building a large pension again (although Labour has threatened to reintroduce the cap).
In the same Budget, the Chancellor also increased the annual allowance for pensions from £40,000 to £60,000. This means you can now save the highest of up to £60,000 or your annual salary into your pension while still getting tax relief.
For many people, this means there’s plenty of allowance remaining – and using it could save thousands in income tax and National Insurance.
Telegraph Money explains how to use your pension to cut your bill.
How to avoid paying higher-rate tax
The easiest way to pay a lower rate of tax on your income is to move down a tax bracket – and pension contributions can easily help you do this.
Currently, workers get a personal allowance of £12,570 on which they don’t pay income tax. You then pay basic-rate, 20pc, on earnings over that, rising to 40pc for anything over £50,270 and 45pc, the top rate, when earnings exceed £125,140.
If your income pushes you over one of these thresholds, you’re paying a higher rate of tax on a small amount of money that you might not miss from your monthly budget. Putting that amount into your pension can save you tax immediately and boost your long-term pot.
One complicating factor is that pension providers have different ways of applying tax relief to your pension, so you need to find out first how they operate.
Some providers use the “net pay”, so your contributions are taken before you pay tax on them. In this case, the calculation is easier. If, for example, you earn £15,000, you could ask your employer to put £2,500 of your wages into your pension. This will take you out of income tax altogether as your salary will drop below the personal allowance.
If you earn £55,000 or £130,000, that is – just above the higher-rate and top-rate thresholds respectively, you could ask your employer to pay £5,000 in. This means you save the 40pc or 45pc in tax you’d have paid and again, it all goes into your pension. You can also use salary sacrifice for this, which is explained in more detail in the next section.
It’s slightly more complex if your scheme uses the “relief at source” system for applying tax relief – and many pension providers do. This is where your pension contributions are taken after you pay tax, then the tax relief is claimed for you automatically.
In this case, you choose the amount you’d like to contribute to take your income down a tax bracket, then pay 80pc of that into your pension. This is because 20pc is added in tax relief automatically, but for tax purposes you’re considered to have paid in the full amount, so it still reduces your income by the desired amount.
If you’re a higher-rate taxpayer, you can also claim additional tax relief – more on that later.
How much you need to contribute can be a complex calculation, as it depends on how your scheme operates, what your salary is and any additional payments you receive, such as bonuses or overtime.
And of course, putting money into your pension reduces the amount of disposable income you have to spend each month, but if you can afford it, it’s worth looking into.
Clare Moffat, of Royal London, says people looking to cut their tax and boost their pension should make contact with their HR department or pension scheme about it.
She added: “If people are near a tax threshold, then it’s worth remembering that gift aid contributions and pension contributions reduce taxable income. A small increase in pension contributions could mean receiving higher-rate tax relief of 40pc, or more in Scotland, and ending up being a basic-rate taxpayer, as well as helping plan for retirement.”
If you’re a long way above a tax threshold you can still pay in enough to move down to the next one – as long as it doesn’t exceed your annual salary or £60,000. However, it will punch a larger hole in your budget and the money will be locked away until you retire, so it’s even more important to check you can afford it.
Use salary sacrifice
The most efficient way to pay money into your pension is through salary sacrifice. This is where you agree to reduce the amount you’re paid in return for non-cash benefits – including pension contributions.
It means your employer puts your contributions straight into your pension, so you don’t pay any tax or National Insurance on them.
There are two types of schemes. Simple salary sacrifice is designed to keep your pension contributions the same, but boosts your take home pay by passing the savings on to you. “Smart” salary sacrifice will keep your take home pay the same, but the savings get added to your pension.
Whichever method you use it will save your employer money, since they pay employers’ National Insurance based on how much you earn. The less you’re paid, the less they have to contribute on your behalf – and some employers will put those savings into your pension as well.
If using salary sacrifice to pay into your pension also takes you down a tax bracket, you could pay a lot less tax – or even none at all.
Here are some illustrative figures of how much you could save if you’re not paying into a pension and start doing so via salary sacrifice.
All you need to do to set this in motion is speak to your employer to see if they offer it. If they do, you can sign an amendment to your contract and start benefiting straight away.
You’ll need to decide how much you want to sacrifice, and there are some limits. For instance, you can’t take your pay below the minimum wage. You’ll also need to think carefully about whether it’s the right option for you.
If you’re already making pension contributions, it might be worth increasing them through salary sacrifice, particularly if you’re just above a tax threshold. Even if you’re already paying into a relief at source pension scheme, it’s still possible to switch to salary sacrifice if you decide it’s right for you, as long as your employer offers it.
You should speak to your employer or pension provider for more information on what your options are and figures tailored to your situation.
Top-rate payer? You can save 60.8pc
If you use salary sacrifice, your employer might decide to pass on the savings it makes in National Insurance to you via your pension.
Additional rate taxpayers would save 45pc in tax, plus 2pc in National Insurance. If the employer passes on its own 13.8pc in National Insurance, this can really add up.
Marco Malagoni, of investment managers Waverton, said: “Sacrificing some of your salary or bonus into a pension is undoubtedly the most effective way of boosting your retirement pot, especially if your employer adds their National Insurance savings. An additional-rate taxpayer can benefit from as much as 60.8pc tax relief, so it can make a huge difference.”
For someone earning £150,000, he added that if they received a £20,000 bonus, they could make huge savings by asking their employer to pay it straight into their pension.
“They would instantly save 45pc in income tax, which is £9,000, plus their 2pc employee’s National Insurance of £400. If the employer also passed on its own 13.8pc National Insurance saving, the gross contribution of £20,000 would be topped-up by £2,760. So the total amount of tax relief gained would be £12,160, or 60.8pc.
“This means instead of taking home £10,600, they could add £22,760 to their pension.”
Again, you just need to speak to your employer to arrange this.
Dodge the 60pc tax trap
Under tax rules, you lose £1 of your personal allowance for every £2 earned over £100,000. This means that by the time you earn £125,140, the top-rate threshold, you have no allowance left. Not only that, you are taxed at 40pc on the extra amount that becomes taxable too.
So if you earn £105,000, you’ll pay 40pc on £5,000, or £2,000. You’ll also pay 40pc on the £2,500 you lost from your personal allowance, which is another £1,000. Suddenly, that £5,000 has cost you £3,000 in tax – or 60pc. But there’s a way around it.
Ms Moffat said: “The lack of threshold changes in the recent Budget mean the rate of tax for those earning between £100,000 and £125,140 can be 60pc or more.
“Someone earning £125,140 could pay a pension contribution of £20,112, which will increase to £25,140 with basic-rate tax relief. That reduces their ‘adjusted net income’ to £100,000, which will give them back their personal allowance and mean they escape the 60pc tax trap.
“As this person will still be a higher-rate taxpayer, they can claim a further £5,028 higher-rate tax relief from HMRC. In effect, the £25,140 pension contribution has only cost them £15,084.”
Mr Malagoni added: “Sacrificing salary or a bonus would be even more tax efficient if it helps reclaim the personal income tax allowance of £12,570. For someone earning a basic salary of £100,000, if they received a bonus of £20,000 they could save 60pc of it in income tax, or £12,000, by putting it straight into their pension.
“Adding the 2pc employee’s and 13.8pc employer’s National Insurance savings brings the total tax relief to 75.8pc.”
“Rather than only taking home £7,600, they could get £22,760 into their pension.”
You can make pension contributions through your salary, or you can make a one-off payment straight to your provider. However, remember that money is generally locked away until retirement. The minimum retirement age is currently 55 and will increase to 57 in April 2028. If you access the money earlier than that you will pay ruinous tax charges.
How to make a lump sum contribution
You might find yourself in a situation where regular salary sacrifice doesn’t work for you. For example, you could be self-employed or your employer simply doesn’t offer it.
Or your income might fluctuate and stuffing your pension with cash at the start of the tax year, which you then can’t touch until you reach retirement age, might be something you’re not willing to do. You might even get to March, the end of the tax year, and realise you have more money than you thought, so are looking to save some tax by boosting your retirement pot.
In these scenarios, a lump sum contribution might be a good option.
Nick Nesbitt, from financial planning firm Mazars, said: “The way this works is that you work out the gross contribution that is required to achieve a certain tax outcome. You then pay 80pc of that amount as a net contribution into your pension.
“It will usually take the form of a payment to the pension provider’s bank account, with a specific reference number, or a payment via an online portal. It’s usually pretty straightforward.
“The pension administrator will automatically credit the 20pc tax relief. You then enter the gross contribution amount on your tax return and receive any higher or additional rate tax relief as a tax rebate, or a reduction in tax due.”
For example, if you earn £60,000 you may want to reduce your income to the lower tax bracket of £50,270. To do this, your gross contribution would need to be £9,730, but given 20pc is provided in tax relief, you only need to pay in £7,784 yourself.
As a higher-rate, 40pc, taxpayer, you’ll get an extra £1,946 on top of that, meaning effectively you’ve only paid £5,838 for a pension contribution of £9,730.
However, there are some things to be wary of when employing this strategy.
Mr Nesbitt added: “You can’t contribute more than your earned income in that tax year. You are also restricted to the annual allowance which is currently £60,000 a year with an ability to carry forward unused allowances from any of the last three tax years.
“Pensions are typically invested, so there is generally an element of investment risk with making such contributions.”
Beware the annual allowance ‘taper’ that hits high earners
Since April 2023, you’ve been able to pay the most of £60,000 or your annual salary into your pension and get tax relief. If you earned £110,000 for instance, you could reduce your income by £60,000 through pension contributions – and earn 40pc in tax relief on the full amount. This would also take you down a tax bracket.
However, under the annual allowance “taper” high earners will lose £1 of this allowance for every £2 they earn over £260,000. Once you have an income of £360,000, your annual allowance will have fallen to £10,000. Making pension contributions beyond this amount will not qualify for tax relief.
You can take advantage of any unused allowance from the previous three tax years.
Don’t forget to claim back your tax relief
As explained above, some pension providers operate under a “net pay” arrangement while others use “relief at source”.
If your employer or personal pension provider runs a relief at source scheme, and many do, tax relief is claimed for you – but only at the basic-rate, 20pc, rate so higher earners could be missing out.
Mr Malagoni added: “I often come across individuals who have failed to claim higher-rate tax relief on their pension contributions, often because it is not clear how the tax relief is actually applied.
“If you are a member of a workplace pension scheme which applies the ‘relief at source’ method, you will probably only be receiving 20pc basic rate tax relief. This means that the pension provider has reclaimed the basic rate income tax and added it to your pension contributions, but they haven’t claimed the higher-rate relief you’re entitled to. You could be missing out on a lot of money.”
There’s a simple fix to this. All you need to do is write to or call HMRC, or fill in a self-assessment tax return. They’ll make the adjustment and you can start benefiting. You can even backdate the amount by up to four years.
Paying into your pension can also cut your capital gains
If you sell some assets, like a second property or valuable personal possessions, you might have to pay capital gains tax. In the past two years, tax-free allowance has tumbled.
Chris Rudden, of online investors Moneyfarm, said: “While in recent years fewer than 3pc of adults paid capital gains tax, that will likely change very quickly in this tax year. As the tax-free threshold drops from £12,300 down to £3,000, millions of people will be drawn into paying, which will be a shock.”
The rate of capital gains tax you pay is based on two things: the type of asset being sold and the rate of income tax you pay.
If you earn more than £12,570 a year, you pay tax on gains you make over the £3,000 annual allowance. At this point, it’s 18pc on a property that isn’t your main home and 10pc for non-property. However, if your earnings pass £50,270, and you become a higher-rate taxpayer, those rates shoot up to 20pc and 24pc.
The same applies to dividend tax, where you get income from shares you hold outside of Isas or pensions. Anything you make over £500 will attract tax and again, the rate you pay increases depending on your tax band.
You can cut your tax on both of these by reducing your income far enough below £50,270 to absorb the gains. Pension contributions, such as by salary sacrifice, is an easy way to do this.
Ms Moffat added: “If you have a gain from selling directly held shares, funds, business assets, personal possessions worth more than £6,000 or a home that isn’t your main home, then you might have to pay the higher rate of capital gains tax when that gain is added to your income.
“Paying a pension contribution in both situations will reduce your taxable income and could mean that you pay less capital gains tax or dividend tax and you satisfy a retirement income need.”
Leave a pension for your loved ones
Unlike Isas and other savings, your pensions generally won’t become part of your estate when you die – this means there’s no inheritance tax to pay.
If you die before your 75th birthday, and the pension is paid to your loved ones within two years, they won’t pay income tax when they access it either. In this scenario, neither of you ever paid tax on it.
If you die after the age of 75, or your beneficiaries access it more than two years after you pass away, income tax will be at their marginal rate.
Use your pension to claim more child benefit (and free hours)
Contributing into your pension, and lowering your pay, can also have other benefits.
From April, the threshold at which families started to lose child benefit increased from £50,000 to £60,000. This means you now have to repay 1pc of what you receive for every £200 someone in your household earns over £60,000.
However, by making pension contributions, you can lower your income and have to repay less – or none at all.
Ms Moffat said: “Pension contributions and gift aid donations reduce income, which can take someone out of the child benefit tax trap, or mean they pay less of a tax charge while also increasing their pension pot.
“Someone earning £70,000 could pay a pension contribution of £6,000, which becomes £10,000 with tax relief, meaning their adjusted net income reduces to £60,000 and they will no longer have to pay the child benefit tax charge.”
In this scenario, it would mean you could keep an extra £666 in child benefit for one child, or £1,106 if you have two and so on. Depending on how your pension scheme pays tax relief (as described above) you will need to input your extra pension contribution into your self-assessment return.
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