Middle income earners can boost their retirement savings and beat a new higher rate of tax by manipulating their pension contributions.
Pensions expert John Lawson, of Standard Life, has explained step-by-step how someone trapped in the new higher rate tax bracket can switch back in to a lower tax rate with their pension.
The tax problem
Around 700,000 taxpayers are expected to pay income tax at 40% rather than 20% as tax thresholds are adjusted downwards. In 2010-2011, a taxpayer could earn £43,875 plus their personal tax allowance before hitting 40% income tax.
For 2011-2012, the threshold is £42,475 plus the personal tax allowance.
Standard Life says many workers not generally regarded as high earners, like nurses, police and junior doctors, are now in the top tax bracket. Other workers on commission and overtime could find themselves paying more tax as well.
National insurance is also an issue. The rate of national insurance for higher earners is rising from 1% to 2%. This rate starts when weekly earnings reach £817, which on an annual basis is £42,475 – the same as the income level at which higher rate income tax starts.
The solution
By adjusting pension contributions, retirement savers can save higher rate tax by expanding their basic rate tax band.
Here’s an example from Standard Life: Tom earns £45,000 a year. In 2010-2011 he paid income tax of £7,930 and £4,209 national insurance, leaving him take-home pay of £32,861.
If he earns the same this year, his tax bill will increase by £80 to £8,010 while national insurance goes up to £4,281, leaving him with £32,709 – £152 less than the last tax year. Tom can save £1,010 income tax by paying a gross pension contribution of £2,525. If Tom is in an occupational pension scheme, he can pay this from his salary before tax is deducted and get the tax relief that way.
Salary sacrifice
Tom can save on national insurance costs if his employer offers salary sacrifice.
Salary sacrifice is giving up part of your salary – in this case £2,525 – if your employer pays the amount sacrificed in to your pension. This would save Tom another £51 in national insurance. The employer saves too – £348 in this example and generally splits the savings with the employee by topping up a pension. If the total
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