How pensions can cut your tax bill

Faith Archer

by , Personal Finance Journalist and Blogger

at Much More With Less

28 Jan 2021 /  

Arrow pointing right in yellow paint on a grey mental shutter

This article was last updated on 08/04/2024

Pensions don’t just turbocharge your retirement savings – they can also help high earners cut their tax bill and hang onto Child Benefit. Basically, pension contributions get taken off your income before calculating income tax, which shrinks your tax bill. By lowering income, high earners may also be able to keep more Child Benefit.

Plus, money inside a pension doesn’t get hammered by income tax or capital gains tax. This also slashes admin, because you don’t have to declare any pension growth or dividends on your tax return. Tax only hits money inside your pension when you start taking it out.

Retirement may seem a long way away. But bumping up your pension contributions can save loads of time and thousands of pounds right now.

Free money from pensions

One of the big attractions of paying into a pension is the free money added by the government, as pension tax relief. Usually, for every £1 you pop in a pension, the government will top it up with another 25p in basic rate tax relief.

Yup, it may seem strange that basic rate income tax is 20% but you get 25p added to every pound. That’s because of the way tax relief is calculated. That 25p is 20% of your total £1.25 pension contribution, including the tax relief.

(Are we having fun yet?)

Pensions work out even better for higher and additional rate taxpayers, because they can get 40% or 45% tax relief respectively.

Limits to the free money

Sadly, there are limits to the government’s generosity! Most people can contribute up to £60,000 or 100% of their earnings (whichever is lower) each tax year, and still get tax relief. Even if you don’t earn enough to pay tax, you can pop up to £2,880 a year in a pension and see up to £720 added in tax relief. However, once your income tips over £260,000 a year for 2024/25, the tax man starts chipping away at how much you can pay into pensions, while still qualifying for tax relief.

Particularly flush? Under the snappily titled ‘carry forward’ rules, you can lump together up to three previous years’ unused pension allowances and make a potentially mahoosive pension contribution. It just can’t exceed more than you’ve earned in the current tax year, and you must have had a pension during the previous years.

Read our ‘Ultimate Guide to Pensions and Tax‘.

How to avoid paying tax on your pension

Tax relief on pension contributions is the magic wand that can cut tax bills for high earners. Higher and additional rate taxpayers can claim a further 25% and 31% respectively when completing their tax return.

Some lucky employees don’t have to do anything to get maximum tax relief, if their workplace pension is run through a trust, or through a net pay or salary sacrifice arrangement. However, if your workplace pension isn’t set up that way, or you have a pension outside work, or are self-employed, you’ll need to claim the extra tax relief yourself. You do this by filing a tax return or you can contact HMRC directly for further information.

Read our ‘self-employed tax tips‘ or find out more about the PensionBee Self-employed pension.

If a higher rate taxpayer puts down their total pension contributions (including basic rate relief added automatically), they can then claim their extra 20% tax relief and get it taken off their tax bill. Similarly, an additional rate taxpayer would see their bill shrink by 25% of their total pension payments.

Example: How pensions can reduce your tax bill

  • If a 40% higher rate taxpayer earned £60,000 during the tax year and paid £8,000 into a pension, their total pension contribution would be £10,000 including basic rate tax relief.

  • By putting the info on their tax return, they could claim the £2,000 owed in higher rate tax relief (20% of their £10,000 gross contribution, which works out as 25% of the £8,000 they actually paid into their pension). If they were to increase their pension contributions by another £10,000 it would only actually cost £6,000!

  • Similarly, a 45% additional rate taxpayer making the same £8,000 pension contribution, automatically topped up to £10,000 with basic rate relief, could receive an extra £2,500 in additional rate relief (25% of their £10,000 gross contribution, which works out as 31% of the £8,000 they actually paid into their pension). Upping their pension contributions by £10,000 would effectively cost just £5,500.

  • In practice, high earners can claim the extra tax relief either as a reduction in the current year’s tax bill, as a tax rebate, or as a change in their tax code, so they pay less tax in the following year. Just remember that tipping into higher rate tax doesn’t flick a switch, so that the whole of your pension contributions automatically get higher rate relief. You only get higher rate tax relief on income over the basic rate threshold.

  • Higher rate tax currently kicks in when income tips over £50,270 a year. Say someone earning £54,270 paid an £8,000 contribution into their pension, topped up automatically with £2,000 in basic rate tax relief to £10,000.

  • Only the £4,000 above the threshold for higher rate tax would qualify for higher rate tax relief, reducing their tax bill by £800. The other £6,000 (under the threshold) would just get basic rate relief.

What if you don’t usually file a tax return?

If you’re a higher rate taxpayer who doesn’t normally do a tax return, because PAYE is taken out of your payslips, it’s well worth signing up for Self-Assessment to cash in on the extra tax relief on your pension contributions. Alternatively you can contact HMRC directly. Plus, if you didn’t realise you were entitled to this extra tax relief, you can claim arrears going back up to the four previous tax years. Kerching!

What is salary sacrifice for pensions?

If your boss deducts pension contributions from your salary through a net pay arrangement or salary sacrifice, you don’t have to wrestle with a tax return to max out your tax relief. Instead, with a net pay arrangement, the pension money is taken out of your pay before any tax is taken off. You benefit from tax relief then and there, with nothing else to do. Increasing your pension contributions leaves less of your salary subject to income tax and therefore you should have a smaller tax bill.

One twist on the net pay arrangement is where you agree to reduce the salary on your contract, in return for your employerpaying a larger amount into your pension. This is known as ‘salary sacrifice’. In addition to the income tax benefits, it also saves you and your employer some National Insurance contributions. It’s worth asking if your employer will add their 13.8% National Insurance saving to your pension payments. Just be aware that reducing the salary on your contract may also reduce future calculations of for example redundancy pay, pension income, statutory maternity pay and paternity pay.

The Child Benefit Hokey Cokey

The government also doles out free money if you have children – but takes it away again once you earn too much. In, out, in, out, shake it all about!

For the 2024/25 tax year, Child Benefit is paid out at £25.60 a week for the oldest or only child and £16.95 a week for each additional child. Child Benefit will only be chipped away once the highest earner’s income hits £60,000 per tax year, at a rate of 1% for every extra £200 in income. Child Benefit payments will therefore only be withdrawn entirely when earning £80,000 a year. This is known as the High Income Child Benefit Tax Charge (HICBTC).

How to hang on to Child Benefit

Here’s how pension contributions can ride to the rescue of your Child Benefit payments. Income, when working out the HICBTC, includes all the stuff like salary from your job, profits from self-employment, any rental income and so on. But – crucially – you can deduct pension contributions, as well as some other things like donations to charity.

So whacking money into your pension brings down your income for the purposes of the HICBTC calculation. For 2023/24, if it limbos lower than £60,000 per tax year, your family can hang onto more Child Benefit, and if it dips below £50,100 you won’t have to give back any Child Benefit at all. From 6 April 2024, bringing your adjusted income below £80,000 will keep more Child Benefit, and below £60,200 you won’t have to give any back.

Example: How pensions can help you hang on to Child Benefit

For 2024/25, if the highest earner in a family with two kids makes £80,000 a year, in theory, that means waving goodbye to all their £2,212.60 in Child Benefit. Ouch! However, if they put £16,000 into a pension, topped up with £4,000 in basic rate tax relief to a total of £20,000, this would bring down their ‘adjusted net income’ for Child Benefit purposes to £60,000.

Suddenly, they don’t have to pay any Child Benefit back, and their pension contribution means they get £4,000 in higher rate tax relief taken off their tax bill.

Diverting £16,000 into a pension means they have gained a chunky £10,212.60, from:

  1. £4,000 in basic rate relief added to their pension pot;

  2. £4,000 in higher rate relief taken off their tax bill; and

  3. £2,212.60 retained in Child Benefit.

Effectively, they are only out of pocket by £5,787.40. Win:win all round for the family finances.

Why Child Benefit is vital for stay-at-home parents

Don’t ignore Child Benefit if you earn over £80,000 but your other half doesn’t! If your family includes a really high earner, they may not want to faff around being paid Child Benefit, putting it on their Self-Assessment tax return and getting it taken away again. If so, they can ask not to be paid Child Benefit at all. If income later dips below £80,000, you can always apply to restart the payments.

However, it can be important to register for Child Benefit in the first place, even if you opt out of the payments afterwards. Child Benefit has a super power for stay-at-home parents or low earners: it protects their entitlement to the State Pension. The person who claims Child Benefit for a child under the age of 12 gets National Insurance credits towards their State Pension, if they’re not working or earn less than £123 a week. You need 35 years of National Insurance Contributions or credits to be able to claim the full State Pension in retirement.

If both parents return to paid work after having children, they may not need National Insurance credits from Child Benefit, if they’re paying National Insurance Contributions on their earnings. But stay-at-home parents could end up with a gaping hole in their State Pension, if they don’t get NI credits from each year they claim Child Benefit. Signing up for Child Benefit also means your child will automatically receive a National Insurance number shortly before they reach 16.

Read more about ‘Child Benefit and the State Pension‘.

Faith Archer is a Personal Finance Journalist and Money Blogger at Much More With Less. Check out Faith and Lynn’s videos about spending during lockdown and after lockdown.

Risk warning: As always with investments, your capital is at risk. The value of your investment can go down as well as up, and you may get back less than you invest. This information should not be regarded as financial advice.

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