If you find more and more of your income is taxed over the basic rate, you are not alone. The higher rate threshold – the point at which you start to pay 40% income tax – has reduced to £41,865 for 2014/15, down from £43,875 in 2010/11.
The Chancellor has announced that the threshold will rise again by just 1% for 2015/16, which is well below the expected rate of inflation. You may also be feeling the full impact of the tax on child benefit and you may find your personal allowance is reduced or even withdrawn if you earn more than £100,000 a year.
The increased tax burden for higher earners is a deliberate policy, as the 2013 Autumn Statement made clear: “The government is committed to a fair tax system in which those with the most, contribute the most”. Since 2010, the government has taken action at every Budget to raise the amount of tax paid by the richest.
Therefore, if you want to reduce the amount of tax you pay, the solution is in your own hands.
Thinking and planning ahead could help you to lessen the rising tax burden. The generous tax reliefs successive governments have given to pension arrangements mean that they have long played an important role in tax planning for high earners.
However, in the last four years, increasingly tight restrictions have been placed on these reliefs, just as the rising burden of income tax has made them all the more valuable. The amounts you can pay in and take out without suffering heavy tax charges have been reduced significantly. Rumours regularly appear that higher and additional rate relief for contributions will be withdrawn, saving the Treasury an estimated £7 billion a year (Taxbriefs, May 2014), but while the reliefs remain, pensions continue to offer significant tax benefits.
The use of pensions in income tax planning is often divided into two areas: pre-retirement and at-retirement. In practice, such a demarcation is an over-simplification because there’s often no longer any link between physical retirement – stopping work – and drawing on a pension arrangement. You may draw benefits, notably tax-free lump sums, before retirement and make pension contributions after your working life has ended. In any event, the move between work and retirement is itself often a transition phased over several years rather than a one-off event.
Your personal contributions to a pension normally qualify for income tax relief at your marginal highest rate(s). Pension contributions reduce your taxable income, so they can help you to avoid the phasing out of the personal allowance, which starts at £100,000 of income, resulting in an effective tax rate of up to 60%. Contributions can also help you to sidestep the additional rate tax band, which starts at £150,000 of taxable income, or the high income child benefit tax charge, which affects those with income over £50,000.
However, the rules on limits for tax relief are complicated, and have just been revised yet again.
Contributions, including deemed contributions from an employer’s defined benefit scheme (e.g. that provides a pension based on your final salary) must be kept within an annual allowance to avoid tax charges. For the tax year 2014/15, this annual allowance is £40,000, down from £50,000 in 2013/14.
Whether or not you wish to maximise your pension contributions, it’s well worth taking some trouble with the arrangements for making them.
As well as the annual allowance, there is also a lifetime allowance (LTA), which sets a ceiling on the total value of your tax-efficient pension benefits. In 2012/13 the LTA was cut from £1.8 million to £1.5 million and on 6 April 2014 it fell even further, to £1.25 million. This reduction was accompanied by the introduction of two new transitional protections, known as Fixed Protection 2014 and Individual
Protection 2014, allowing you to keep an LTA over £1.25 million.
It’s now too late to apply for Fixed Protection 2014, but Individual Protection 2014 is still available. If the total value of all your pensions was over £1.25 million at 5 April 2014 this protection may be relevant to you, and you should get advice about it.
When you decide to draw your pension benefits you have to decide the balance between lump sum and income. If you have a personal pension or other defined contribution pension scheme, the chances are that you should take the maximum possible lump sum. This is mainly because the lump sum is tax-free, whereas any income is fully taxable. Changes planned for 6 April 2015 will remove all restrictions on the lump sum, although the tax-free amount available will not change.
If maximising the lump sum is the right move, that does not necessarily mean you should draw all of it at once. With modern pension arrangements it is possible to draw benefits in stages, and one option might be to supplement your income tax-free through a series of lump sums. How you deal with the rest of your fund can then be a more complicated issue.
From April 2015, you will have complete flexibility over what you do with a defined contribution pension after age 55, including taking the whole amount as a lump sum. However, doing that could mean you face a high tax bill on it and leave you without enough income later in retirement.
Before making any decisions, you should always explore your options with a trusted advisor.
To receive a complimentary guide covering Wealth Management, Retirement Planning or Inheritance Tax Planning, produced by St. James’s Place Wealth Management, contact Leigh Bennett of St. James’s Place Wealth Management on 01424 236500 or email leigh.bennett@sjpp.co.uk