Can your pension help you escape a tax trap?

Pensions aren’t just about securing an income in retirement; they can also help you avoid some common tax traps.  

Taking the sting out of becoming a 40% taxpayer   

Once your income rises above £50,270 you begin to pay 40% tax on your earnings and profits above this threshold. Earning just £1 over this amount means you also lose other valuable tax benefits too. The amount of tax free interest you can receive on your savings each tax year drops from £1,000 to £500 and you lose the ability to benefit from the Marriage Allowance which allows a non-tax paying spouse or civil partner to transfer part of their tax free Personal Allowance to you and can be worth up to £252 in the current tax year.  

The £50,270 threshold from which 40% Income Tax becomes payable hasn’t changed since April 2021, and is set to be frozen at this level until April 2031, as incomes rise, an increasing number of people are being caught in the 40% tax net.    

Making full use of your ISA allowance each tax year becomes increasingly important as any income or gains they generate are free from tax. Similarly, pensions can also pay an important role in reducing your overall tax bill and restoring lost allowances.     

Avoiding the 60% tax charge 

It’s the ambition of many to reach an income of £100,000, but it does come with an unexpected sting in the tail.   

For every £2 of income over £100,000 you lose £1 of your tax-free Personal Allowance of £12,570. This means that any earnings between £100,000 and £125,140 are effectively taxed at 60%. When you add on the 2% National Insurance payable that means you only keep £38 of every £100 earned.  

One of the most effective ways to get out of this tax trap is to invest in your pension. If you are an employee, ‘salary sacrifice’ can be very tax efficient for both you and your employer.  

As an example, an employee with earnings of £125,140 who chose to give up £25,140 of salary in return for an employer pension contribution of the same amount, would save £15,084 in Income Tax (60%) and 2% in National Insurance (£502). This means they would have £25,140 going into their pension at a cost to them of £9,554.   

Their employer would also escape Employer’s National Insurance on the money they pay into their employees' pension, saving them 15% or £3,771 in this example.  

Although pension contributions via salary sacrifice are set to be capped from April 2029, with both employer and employee National Insurance payable on excess contributions over £2,000 each tax year, they remain a very tax efficient way of investing.