Six Reasons to Top Up Your Pension

With the end of the 2022/23 tax year almost upon us, time is running out to make the most of your tax-free exemptions and allowances before they disappear forever.

There is so much more to pensions than just providing an income when you stop working. While this of course their main function, they can also help you and your business pay less tax, give your children a head-start in retirement, and even enable you to retain valuable state benefits. With time running out, maximising your pension reliefs 2022/23 should now be racing up your list of financial priorities. In many cases, if you don’t use this year’s allowances, you lose them for good. So, here are six reasons to top up your pension:

1. Pay less Income Tax

Saving tax is one of the simplest ways of nudging you closer to your financial goals. Anything you pay into a pension (within certain limits) receives Income Tax relief at 20%. This means that every £80 you pay into a pension you get a £20 top up from the government. If you’re in one of the higher Income Tax brackets, the perks are even greater. You can claim the extra tax relief back via your tax return. That’s unless your employer deducts your pension payments through PAYE, where you’ll receive full tax relief at source.

For most people, the maximum you can pay into a pension and get tax relief is the lower of £40,000 (rising to £60,000 for the coming tax year) or 100% of earnings, offering plenty of scope to save for your future in a tax efficient way. There are, however, a couple of scenarios where your annual allowance might be lower.

First, if your earnings are particularly high (£240,000 a year plus), your allowance could be as low as £4,000 due to something called the tapered annual allowance. Second, if you’ve retired or semi-retired and started drawing flexible income from your pensions, the money purchase annual allowance might also restrict your tax-deductible contribution limit – again to £4,000. You can pay in more if you want to, but you won’t get tax relief.

2. Carry forward unused allowances

In some cases, you can pay in more than your annual alowance in a year and get tax relief. This is due to something called carry forward, which could boost your annual allowance to a whopping £160,000.

Carry forward rules allow you to make use of any unused annual allowances in the previous three tax years, provided you were a member of a UK-registered pension scheme during this period. So, if your pension contributions were £10,000 in each of the previous three tax years, you could potentially carry forward £90,000, raising your annual allowance to £130,000.

However, it’s important to note the 100% earnings cap still applies. For instance, if your total earned income is £70,000, that’s the most you can pay into a pension and receive tax relief. If you’ve been subjected to the tapered allowance in any of the past three tax years, the calculation can become more complicated. It’s therefore essential to take professional advice in this area.

3. Avoid the Child Benefit tax charge

Child Benefit is a valuable income source for many families – especially right now with the cost of living crisis squeezing your household purse strings. But if you receive child benefit, and you or your spouse/partner earn more than £50,000, you might have to pay a charge.

Once annual income exceeds £60,000, the charge is equal to child benefit, wiping it out completely. One solution here is topping up your pension, as it can reduce your adjusted net income (your total taxable income for the year).

Let’s look at an example: Your total income for the year is £60,000. If the total you pay into pensions – whether workplace or private – is £10,000, your net adjusted income falls to £50,000. This means the High-Income Child Benefit Tax Charge would not apply. For families with two children, the total saving would be £1,885. What’s more, as you pay higher tax on earnings above £50,270, you would get 40% relief on most of your pension payments, meaning the effective tax saving is almost 60%.

4. Save Corporation Tax

Are you an owner/director of a private limited company and facing down a painful corporation tax bill this year? If so, paying into a pension can help reduce what you pay to HMRC, while also giving your retirement savings a shot in the arm. That’s because company pension contributions paid from pre-tax profits are deemed an allowable business expense, saving you up to 19% in corporation tax.

For instance, your pre-tax profits are £50,000. If you make a £20,000 pension contribution from the company, your profits fall to £30,000 – saving you £3,800 (£20,000 x 19%) in tax. Furthermore, you’re not restricted to 100% earnings rule – only the £40,000 annual allowance applies – which is useful for those who take a smaller salary and the rest in dividends for tax purposes.

With the top rate of corporation tax rising to 25% from 6 April, the tax savings next year could be even greater. But before making company pension contributions, it’s worth speaking to an expert who can make sure your pension contributions are suitable, affordable, and set up correctly.

5. Retain your personal Income Tax allowance

Only a fraction of the population earns more than £100,000 a year. But if you’re one of the lucky ones who do, there are some tax penalties to be aware of. Most people get an Income Tax allowance, which means the first £12,570 you earn is free from tax. However, if you’re a high earner, this allowance might reduce or even be lost. For every £2 you earn above £100k, you lose £1 of your personal allowance. Therefore, once income exceeds £125,140, your personal allowance disappears.

However, as explained in Point 3, paying into a pension can reduce your net adjusted income. For example, if your income is £125,000 and you pay £25,000 into a pension, your taxable income for the year would fall to £100,000. This would save you £10,000 in Income Tax, and enable you to reclaim your personal allowance, resulting in an effective tax saving of around 60%.

6. Save for a child’s future

Putting money away for a child’s retirement may seem premature. It could be 50 to 60 years until the money is needed. But starting a pension as early as possible can bring sizeable benefits, most notably that the money has so much time to grow.

While this doesn’t involve topping up your own pension, you can open a junior SIPP (self-invested personal pension) for a child as soon as they are born, and can pay in up to £2,880 a year, grossed up to £3,600 due to tax relief. As the term ‘self-invested’ suggests, you have the carte blanche to choose how to invest your child’s savings, whether that’s cash, stocks and shares, bonds.

Given the lengthy investment timeframe, your child can typically afford to take more risk, so shares may be your best bet. It’s important, however, to sound a note of caution here. As with any pension plan, the money is locked up until the minimum pension age, which under current rules is age 57. This means the money cannot be used for immediate financial goals such as paying for a wedding or funding a first home deposit.

If you would like to talk about any of the issues in this article or need more general help with your finances, please get in touch with us.

This article first appeared on Unbiased.