Can a pension help you beat the tax traps?

family playing in a field

As incomes rise more people are being caught in ‘tax traps’ that can mean they pay significantly higher levels of tax once their income exceeds a given level.

The good news is that in many cases paying money into your pension can help you avoid these traps.

What are the traps?

The child benefit tax trap

If you’re the highest earner in your household with an income of more than £50,000 and you or your partner claim child benefit, you’ll need to pay the ‘High Income Child Benefit Tax Charge’.

For every £100 of income over £50,000 you’ll need to pay back 1% of the child benefit that you or your partner receive. If your income is £60,000 or more, you’ll need to pay back the full amount. If claiming for two children, this amounts to £2,074 and for three children £2,901 for the 2023/24 tax year.

How to beat it: The income that is used to assess whether you’re liable to pay the Child Benefit Tax Charge is your income after pension contributions. For every £80 you pay into a personal pension HMRC pay in a further £20. So, paying £800 into your pension which is topped up to £1,000 by HMRC allows you to reduce your income by £1,000.

Someone with earnings of £55,000 claiming child benefit who contributes £4,000 to their pension would see this topped up by £1,000 by HMRC. This £5,000 total payment would reduce their income to £50,000 meaning they are no longer liable for the Child Benefit Tax Charge.  In addition, they could reclaim additional higher rate tax relief of £946 via their tax return.  

The personal allowance tax trap

Once your income exceeds £100,000 the amount of tax-free income you can enjoy of £12,570 is eroded by £1 for every £2 of income over £100,000. Once your income reaches £125,140 your tax-free allowance is lost completely. This means that income between £100,000 and £125,140 is effectively taxed at 60%.

How to beat it: For many of those caught ‘salary sacrifice’ can be a very tax efficient way to mitigate the impact. An employee with earnings of £125,140 who ‘sacrificed’ £25,140 in return for an employer pension contribution of the same amount would see £25,140 going into their pension at a cost to them of £9,552.

‘Salary sacrifice’ can also be advantageous to employers, who save employer’s National Insurance contributions on the amount they pay into their employee’s pension.   

The 45% tax trap

The Chancellor’s announcement that from April 2023 the point at which 45% Income Tax becomes payable would reduce from £150,000 to £125,140 caught many by surprise. As incomes increase, a growing number of people will find themselves paying 45% Income Tax for the first time.  

How to beat it: Many with incomes over £125,140 will be able to reduce their tax liability by paying additional sums into their pension, either by using their £60,000 annual allowance or if they wish to pay in more, by ‘carrying forward’ any unused annual allowance from the previous three years.

Those with incomes of over £200,000 should take advice as their annual allowance of £60,000 may be subject to a reduction depending on their circumstances.

The tax treatment of pensions depends on individual circumstances and may be subject to change.

The value of pensions can fall and you may get back less than invested.

NFU Mutual Financial Advisers advise on NFU Mutual products and selected products from specialist providers. They will explain the advice services and charges.

Financial advice is provided by NFU Mutual Select Investments Limited.