Pension Tax Breaks

In these times of low interest rates and volatile markets it is important to gain every last advantage you can, but incredibly British tax payers are failing to take advantage of the tax breaks available to them.

In the past 10 years almost £89bn in tax relief has been wasted in the UK with an estimated £12.6bn due to go unclaimed in 2012. The Unbiased 2012 Tax Action Report showed that, after unclaimed tax credits, the biggest area of waste this year will be tax relief on pensions.

Most people appreciate that tax relief is available on pension contributions but it is worth reiterating the key benefits that make this such an appealing method of investing, as well the pitfalls that can catch out the unsuspecting investor.

First of all, irrespective of your personal tax rate, any contribution you make to a pension will receive 20% tax relief at source. In other words if you want to invest £10,000 you only need to write a cheque for £8,000. The pension provider will immediately credit your investment with £2,000 and then claim the tax relief from HMRC on your behalf.

An overnight increase of 20% in the value of your investment sounds great but if you are a higher rate tax payer then you can potentially reduce the cost of your investment even further by claiming an additional 20% tax relief (or 30% if you are in the 50% tax band) on your self-assessment tax return. However, before you make that lump sum investment check that you are eligible to claim all of the available relief.

There is a common misconception that just because you pay higher rate tax that you can claim all of the additional relief on any pension contribution you make. Higher rate tax relief is given by extending your basic rate tax band by the amount you paid into the pension so consequently it is limited to how much of your income would normally be taxed at the higher rate.

An example probably best explains this. Someone with normal personal allowances will only start to pay 40% higher rate tax when their income exceeds £42,475. If they make a £10,000 pension contribution this then increases their high rate threshold to £52,475 effectively saving 20% tax on that extra £10,000 of income. However if their earnings are only £50,000 then they would only be able to claim relief up to that amount of income, effectively wasting the remaining £2,475.

The most sensible solution may be to reduce the contribution down to £7,525 and pay the balance in the next tax year so that you can claim all of the extra relief. With the end of the tax year fast approaching this is an ideal time to consider making lump sum investments to pensions and ensuring that you don’t lose any of the tax benefits that you are entitled to.