I’m enrolled in a workplace pension. This tax year I will earn over £110,000 under PAYE and I have found out I will lose part of my tax-free allowance.
Will paying £11,000 as an additional contribution to my pension offset any extra tax?
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The £100k tax trap: For every £1 of taxable income you have above that threshold, you lose 50p of personal allowance
Steve Webb replies: For most people, the first £12,570 of taxable income each year is ignored when their tax bill is worked out. This is the standard personal allowance and has been fixed since 2021/22.
However, since 2010/11, anyone with total taxable income over £100,000 per year starts to have some of that personal allowance clawed back.
For every £1 of taxable income you have above that threshold, you lose 50p of personal allowance.
This continues until your entire personal allowance has been wiped out at incomes of £125,140 or above.
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The consequence of this system is that someone in the band between £100,000 and £125,140 loses 60p from each extra pound that they earn.
This is because each pound costs them 50p in lost tax-free allowance, so earning an extra pound adds £1.50 to their taxable income, and 40 per cent of this is 60p.
When this system was first introduced over a decade ago, very few people had total taxable income above this threshold, and £100,000 per year is obviously still a high income.
But the Institute for Fiscal Studies estimates that by 2025/26 around 1.6 million people will have some of their personal allowance withdrawn as the long-term freeze of this threshold starts to bite.
As your question suggests, however, there is something that you can do to mitigate the impact of this system.
When your income is tested against the £100,000 threshold HMRC first deducts things like pension contributions and charitable donations. As a result, the more you put into a pension, the less you are affected by the tapered personal allowance.
This in turn makes saving into a pension particularly attractive for someone in your position, and you can use either a workplace pension or a Sipp (Self-Invested Personal Pension) to do it.
To be precise, each £1 that goes into your pension actually only costs you 40p if you are in this band of earnings.
The way this works is that if you pay in 80p, this is topped up by 20p in basic rate tax relief, delivering £1 into your pension.
But when you declare this £1 gross contribution on your tax return this reduces your taxable income by £1.50 (because you also get back some of your personal allowance) so you save 60p in total.
Out of this 60p you have already received 20p in basic rate tax relief into your pension so you get a tax rebate of the remaining 40p.
In your particular case, it is worth noting that if you are earning £111,000, you don’t have to write a cheque for the full £11,000 to your pension provider to get back down to the £100,000 figure.
Provided that your workplace pension provider operates the ‘relief at source’ system for paying pension tax relief, you only have to pay in the amount net of basic rate relief (£8,800), and HMRC will top it up to the full £11,000.
On the other hand, if your workplace pension scheme delivers tax relief through the ‘net pay arrangement’ then as long as you can pay through the pay packet you will immediately get full 40 per cent relief on your contribution.
Then, when your tax affairs are reconciled after the end of the tax year, you should benefit from the extra pension contributions via an enhanced personal allowance
Without complicating things too much, you could also explore with your employer if there is any potential for making this contribution via a ‘salary sacrifice’ arrangement, which could be even more beneficial.
Furthermore, if you were to convert this extra amount into a regular contribution this might also attract additional employer funds if you are not already getting the maximum ‘match funding’ offered by your employer).
One important point to mention is that you will only get the additional tax relief if you let HMRC know about your contribution via your tax return.
Under the ‘relief at source’ system, your contribution automatically gets basic rate tax relief (via a payment from HMRC into your pension fund) but the higher rate relief and improved personal allowance will only be applied if you declare your contribution on your return.
If you are in a ‘net pay’ scheme, an increase in regular contributions should be dealt with automatically, but you still need to declare lump sum contributions on your tax return to get the tax relief.
It is worth mentioning that the use of pension contributions (and charitable donations) to bring your income below a threshold applies to other areas of the tax system.
There are two of particular note.
– Access to tax-free childcare, where there is a ‘cliff-edge’ cut-off at £100,000. Having taxable income below the threshold can make someone substantially better off than having an income slightly above if this brings them into entitlement for tax-free childcare.
– Reducing the impact of the ‘high income child benefit charge’.
At present, in couples where one partner earns £50,000 per year or more, a tax charge has to be paid where the couple receives child benefit. But, as described above, the income which is tested against the £50,000 threshold is net of pension contributions.
This means that saving more into your pension – which may be worthwhile for its own sake – could bring an extra payback in terms of reducing or eliminating the high income charge.
