Following on from my last blog where I talked about why you should contribute to a Pension rather than a New Individual Savings Account (NISA) this time I would like to write about how to maximise your pension contributions. In the current tax year 2016/2017 it is possible to contribute up to £170,000 to a pension in one lump sum payment and receive full tax relief at your marginal rate using a process called Carry-Forward.
(Explanation - you can contribute whatever you want to your pension per annum, it is only the tax relief eligibility that is being considered in this discussion).
Eligibility – in order to take advantage of Carry Forward tax relief on pension contributions you would need to have been a member of a registered pension scheme at some time during each of the years you want Carry Forward to apply, even if you were not making any or full contributions.
You can only make personal contributions up to a maximum of earned income (dividends do not count for this purpose, for example) and you can only claim higher rate relief to the extent that you have actually paid it in the year that Carry Forward is being claimed (it is not sufficient to have paid higher rate tax in the actual year Carry Forward is being claimed FROM).
There are separate rules governing those individuals that have Adjusted Income in excess of £150,000 (unless they have Threshold Income of less than £110,000) – details of these rules are available on request but are not considered in this example (see last paragraph in this bulletin below for details).
Carry-Forward is a process where you use your annual allowances which are the maximum that you can contribute into a pension in any tax year for previous tax years and still receive full tax relief at your marginal rate (note – contributions must also include any made by your employer on your behalf and state Pension does not count for this purpose). You effectively Carry-Forward the allowances for previous tax years to the present year. Let me explain how it works in practice.
If we take the scenario of a client who is aged 64 and is looking to retire in the next few years. The client has recently inherited £55,000 and has not been making pension contributions. The client has a salary of £100,000 per annum in the 16/17 tax year and would like to maximise their pension contributions that attract tax relief at the marginal rate.
The Carry Forward rules state that the current year’s allowance has to be used first (£40,000 for 16/17). Any surplus (in this case £15,000) can be applied against the three previous tax years, commencing with the first – 13/14 – in which the Annual Pension Allowance was £50,000.
The maximum amount of pension contribution the client can make in the 16/17 tax year and still be able to claim full tax relief is £100,000.
Here is a table to illustrate how it operates in the given example:
Due to the tax reliefs that we discussed in the previous blog the effective cost for the client in the 2016/17 tax period due to tax relief would be £33,000 for a £55,000 pension contribution. The client would make an £44,000 payment to the pension provider who would claim back basic rate tax relief to add a further £11,000 to the fund. As a 40% tax payer the client would also be able to claim a 20% tax reduction on these contributions by claiming through their self-assessment on her income that would have been subject to higher rate tax.
This works much the same way for employer contributions the only difference is that instead of receiving income tax relief it receives corporation tax relief. We will cover how it works for employer contributions in a future bulletin.
The example is deliberately limited to earnings of £100,000 as above this it becomes more complicated as individuals earning over £100,000 start to lose their personal allowance at a rate of £1 for every £2 of income above £100,000. It is further complicated for individuals earning over £150,000 as their annual allowance is reduced by £1 for every £2 over £150,000. The maximum reduction is £30,000. These complications do open further opportunities that we would be happy to discuss. For any financial advice Bradbury Hamilton, are able to advise. Visit www.bradburyhamilton.co.uk or call Sheriar Bradbury on 020 7220 7274.